Small-cap equities had a resurgent year in 2009 as the average fund in the Morningstar UK Small-Cap Equity category gained 46% for the year-to-date 30 November 2009; that lofty return made it the best performing Morningstar UK equity category this year. But we would urge investors to err on the side of caution, despite the allure of such big gains over short periods of time.
Close Special Situations topped the tables by posting a staggering return of 242% in 11 months in 2009. But at just £17 million, it’s able to be extremely nimble and dip into micro-caps in ways that much larger funds simply can’t attempt. That said, it’s not always about size. Of a similar level of assets is AEGON UK Smaller Companies, at £13 million, yet a respectable return of 41% to end November places the fund in the 53rd percentile of the category.
A closer look at what has been driving the returns of the hottest funds in 2009 highlights their inherent risk. For example, those funds that ranked in the top-quartile of the category for the year-to-date to end November 2009 tended to have higher stakes in the cyclical industrial materials and energy sectors. Exposure to the smallest companies also helped as the FTSE AIM All Share TR Index rose 68% over the period. The top-quartile performers in the Morningstar UK Small-Cap Equity category over the period held an average weight of almost 60% in micro-caps while those that landed in the bottom quartile held an average exposure closer to 40%. Although micro-caps provided a shot in the arm for many small-cap offerings this year, investors should keep in mind the risks. During the financial crisis, small and micro-cap stocks suffered badly as cheap credit became scarce, liquidity dried up and losses were amplified, particularly in 2008.
Capacity also becomes an issue with small-cap funds. As funds gather assets and grow in size, their ability to move nimbly in and out of meaningful positions without adversely affecting the stock price becomes difficult. The Cavendish Opportunities fund, which returned 74% for the 11 months to end November, is able to invest almost 70% of the fund in micro-caps due to its small asset base of £24 million (as at November 30). Although the fund has done well this year, if it grows at a fast pace its ability to take big stakes in micro-caps will be limited.
Slow and steady wins the race
Managers who have a low turnover approach to small-caps can mitigate to
a degree the liquidity and asset size constraints. Those funds we hold
in higher regard tend to be less racy and take a steadier, long-term
approach to investing and have tended to lag the pace-setters during the
sharp rally this year. The Elite-rated Standard
Life UK Smaller Companies has gained 42% for the year-to-date 30
November 2009 but the fund ranks in the 47th percentile of its category.
However, we would expect such underperformance in this market
environment. Veteran manager Harry Nimmo invests in companies with very
high earnings visibility and shuns blue-sky or recovery stocks and
highly-leveraged or heavily-indebted balance sheets--the type of stocks
that have bounced back sharply in 2009. The fund holds up better than
most of its peers in down markets, as it did in 2008, which stands it in
good stead over the long term; it ranks in the top decile of the
Morningstar UK Small-Cap Equity category for the five year period to
November, 30 2009.
Another fund we like for small-cap exposure is the Superior-rated Old Mutual UK Select Smaller Companies, although its high TER of 1.95% is a blemish in our view. The fund has lagged higher-octane fare and ranks in the 71st percentile for the 2009 period to end November. Dan Nickols only invests in stocks that have the potential to exhibit strong earnings growth but also have high cash flow yields; he subsequently avoids speculative issues as companies must already be posting earnings. Nickols’ strategy is proven over the long term and the fund ranks in the top decile of its category for the five years to November 30, 2009.
We also like the strategy applied at Baillie Gifford British Smaller Companies, although the fund is rated Standard due to its relatively new manager Douglas Brodie. Brodie does, however, use the house style--he takes a long-term view and opts for stocks with steadier growth prospects, solid balance sheets and will hold positions for 3-5 years. The fund has fallen behind its average peer in 2009--and falls in the bottom performance decile--but it held up relatively well during 2008 due to its quality bias; the fund ranks in the top-quartile for the five years to end November 2009.
Although investors may feel like they are missing out on heady returns by investing in a relatively steadier fund, those that manage downside risk better than their peers have a better shot at outperforming over the long term. Both the Standard Life and Old Mutual offerings have among the lowest downside capture ratios in the category over the past five years and both have posted top decile returns over the same period. Furthermore, our studies suggest investors have a better experience using funds that are less volatile. While both funds are looking a little lacklustre at the moment, investors should exercise caution as funds that have shot the lights out in 2009 may not serve them well over the long term. Investors should therefore take the hot returns of this years’ best performing small-cap funds with a pinch of salt.