Investors set to return, small cap in hand

A recent market rally has encouraged investors to look further afield from the Footsie, but investors should be wary of the risks.

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After a long period of hype about bonds, the pendulum may be about to swing back towards equities. The recent surge in stock markets has prompted many investors to return to funds holding minnow companies in the hope of bagging decent future returns.

UK small cap funds specialise in holding companies listed outside the FTSE 350 Index, or not listed at all. The benefit of such investments is the possibility for greater returns, albeit at a greater risk, but after a sustained period of nervousness, investors are beginning to look again at this sector.

They are attracted by some decent performances over the past 10 years. Only five funds out of 76 in the Morningstar UK Smaller Companies sector failed to make a positive return over a period that included the worse economic downturn since the Second World War and the massive drop in dotcom stocks after the technology, media and telecoms bubble in 2002.

According to the latest research from trade magazine Money Management, Marlborough's Special Situations fund would have turned an initial £1,000 investment into an impressive £4,497 over the last decade, an annual growth rate of 16.2 per cent.

Giles Hargreaves, manager of the fund, says this was the result of holding a mixture of micro cap and unquoted companies. He says: "The shares we held have either come through unscathed or had fallen so much they couldn't fall anymore. We selected non mainstream companies and were careful about having too much in one particular sector."

An example of Hargreaves' handiwork includes an investment in Brazil-based developer Agrifirma, which specialises in transforming barren land into grain farms. While the company is privately-owned, it expects to apply for entrance to the Aim soon. Other holdings in the Marlborough portfolio include online gambling brand Paddy Power and Asian construction specialist West China Cement.

Good returns in this sector are not limited to just the one fund though. The Artemis UK Smaller Companies fund returned £3,294 over 10 years from an initial £1,000 investment while Aberforth's UK Smaller Companies fund returned £2,422.

However, such decent returns don't tell the whole story. At the other end of the sector the very worst performers are a world away from those funds at the top.

For example, £1,000 over the same 10-year period in the Smith & Williamson Special Situations fund would have lost the investor £374 from the original investment, although the fund has enjoyed a recovery in the past four months. The second worst performer was Henderson's UK Smaller Companies fund, which returned £708 from the initial £1,000 investment, although it was particularly badly hit from a significant tech bias during the TMT bubble.

It is worth remembering though that many of these funds invest in well-known brands, despite being labelled "small cap". These so-called smaller companies include well-known organisations such as Christian Salvesen, the logistics firm, Fyffes, the fruit wholesaler, and even Premier League football club Tottenham Hotspur plc.

But it is not just over a longer, period where there is money to be made. A short-term investment in the best performing small cap funds over five years will have also paid off.

The Old Mutual Dublin UK Select Smaller Companies fund returned an extra £892 on the initial £1,000 invested over five years, equating to an impressive annual growth of 13.6 per cent. Its sister fund returned an additional £675 on the same investment, while Standard Life's UK Smaller Companies fund returned £1,623.

Like the 10-year results, however, a small number of poor performers remain. Canlife's UK Smaller Companies fund, for example, lost £395 from the initial £1,000, while Rensburg's UK Micro Cap fund is also among the poorest performers, down £247 over that period.

Fund managers agree that, even within the UK Smaller Companies sector, there are a myriad of choices, from funds that invest in larger firms to those that prefer micro cap companies.

Stuart Sharp, director of UK Smaller Companies at Rensburg, says the performance of the Micro Cap fund was largely the result of restrictions on the fund mandate, as 80 per cent of the fund had to be invested in companies with a market cap of less than £100m.

He says: "The micro cap fund will always be a more specialist fund because of the restrictions. That will probably be slower to move than the [Rensburg] Smaller Companies fund, because that has a much broader mandate."

Sharp says while investors were rightly fearful over the past 18 months in light of the global financial downturn, there are now real signs that the market is turning.

"There are enough straws in the wind to look at our market and say 'yes, recovery is coming', albeit perhaps the upward momentum will be less than in previous upturns," he says.

"Japan is out of recession, the American property market has bottomed, Germany is coming out of recession, and French GDP is positive. Fear has dissipated. There is potential for six to nine months of gently improving numbers across the board and growth will be more resilient."

Sharp's views are echoed by many fund managers across the sector. Gervais Williams, head of small caps at Gartmore, explains the current period of credit constraints on both businesses and consumers will affect which stocks perform. But this does not mean there will be a shortage of strong performances over the coming period.

"The general trend where consumers can borrow at will has come to an end. For that reason, the consumer sector is constrained and the housing market will be constrained. So there are some big negatives.

"However, things could be more exciting in some of the traded goods sectors. Products like software and manufacturing could be massive and that is another reason why these funds might do well."

Investors are reminded of some of the risk-trends over the past 10 years. The spread of performances in the UK Equity Funds sector, which permits investment in larger cap companies shows that the spread between good and bad funds is much slimmer there than in small cap funds.

The best performer in the Morningstar UK Equity sector over five years was the Rensburg UK Mid Cap Growth fund, which returned £1,772 on the initial £1,000 investment, £120 less than the best performing small cap fund. However, the worst performer was the New Star Hidden Value fund, which lost £256 – nowhere near as bad as the worst performing small cap fund, which lost £100 more.

Despite this, managers and analysts are agreed that interest in equity funds is certainly returning, although small cap funds will always remain the choice for only the more adventurous investors.

Victoria Stewart, fund manager at Royal London Asset Management, is among those managers acknowledging the positive signs on the horizon.

"In the second six months of the past year there has been a rebound and that has been driven largely by a sector-led rotation where companies that had refinanced became less weak. The challenge for the rest of this year is largely going to be about maintaining the performance of the fund."

Fund managers are less split about the outlook for equities now than they were a month ago, but, despite the recent strong rally and increased bullishness of investors, a few remain cautious.

There is, though, a sense of normality returning to equity markets, but the debt cycle is not over and many believe companies will still have to issue additional equity to get through the recovery. However, managers and institutional investors agree that as long as the fear that was lingering in the market does not return, it could be the start of a longer term bull run.