If I could only pick one type of fund, which would it be?
I try not to give our clients heart attacks. I put this down to basic decency, but cynics might argue it’s because not killing customers is bottom-line accretive. Whatever. The fact is I want our clients to be get rich slow and survive trying, so performance-induced coronaries are out.
But what if I didn’t care about fibrillating our investors? What if I was gunning purely for maximum ten-year total returns instead? Well, then I’d only hold small-cap value funds. And specifically small-cap value funds that are both well run and right-sized. Because they generate gob-smacking returns over the long term (they can just be a little bumpy on the way).
Let’s do the data: If the UK stock market repeats the same rates of return it saw over the last seventy years, then — if you invested £1,000 today — over the next 25 years you would earn £96,000 (ninety six thousand) more by investing in small-cap value stocks than you would by holding large caps (£16.4k vs £112.6k).
Those figures are from Scott Evans, Paul Marsh and Elroy Dimson, via the Numis 2022 Annual Review. They calculate that, since 1955, large UK-listed companies annualised 11.2% a year. Not bad; but small caps annualised 14.8% over the same period, and small-cap value stocks made 18.9%.
A 7.7% gap might not sound enough to warrant a £96k lead on a £1k investment, but that’s the magic of compounding for you.
This is the first reason why active reigns supreme in this area: There are no passive vehicles tracking this index, at least not in the UK, anyway: It’s too small and illiquid to house a viable, scalable tracker. This means that, unless you’re picking the stocks yourself, the only way to access these returns is through actively-managed small-cap vehicles.
The second reason is this is a highly inefficient market and, seeing as many companies who find themselves in the small-cap value bucket are on their way to going bust, there are obvious gains from paying an expert to sort the wheat from the chaff.
This is also an area where local knowledge pays off. There are some decent global small-cap fund managers out there, but do they know the companies, management teams and competitors of a country specialist who’s lived and worked in their market their whole life? Unlikely.
Working within this alpha-rich environment, it’s only mildly optimistic to believe a talented manager could, after charges, earn you 2% above the small-cap value index. Add that onto your 18.9%, and you’re growing that gap between you and the large caps by an extra £73k.
The weird thing is small-cap value funds are as rare as hens’ teeth. Of the 51 funds in the IA UK Smaller Companies sector, for example, I know of two, perhaps three, out-and-out value funds. This is typical across other markets too.
Lots of reasons: For one, they’re harder to run than, say, a small-cap quality-growth strategy. You’re dealing with companies that, in many cases, don’t have the safety blanket of a killer product and/or a bullet-proof balance sheet. So there can be almost as many landmines as there is land (another reason you don’t want the tracker here). You’ve got to know what you’re doing, and many who try don’t last long enough to get good.
They’re also labour intensive: More often than not you’re entering a brief fling with a stock while it recovers, not partnering with it for life. So trading activity is usually busier.
Thirdly, value’s been an unfashionable neighbourhood for the last ten years, while small caps have hardly been a des res. This means most C-suites have had little interest in offering a small-cap value product. At the same time, young investors entering the business have only seen growth and large caps winning, so staking your career on grubbing about in the market’s bargain bucket is an unlikely call.
Finally they’re not especially scalable. A boutique manager with a love for the job could earn a very nice living off an appropriately sized small-cap value offering, but that same fund could get lost down the side of a mega-corp’s sofa. It’s just not worth their bother, so they usually don’t.
It is, however, worth your bother. And mine too. Which is why I always make sure I have some decent exposure in our portfolios to these pocket rockets. But particularly today, and particularly in the UK: The country, the style, and the market cap segment have been out of favour for so long you can just feel the pressure building. And when it rips, it will rip big. And if you weren’t in it, you’ll have missed the best bit.
Don’t ask me when though: I have no idea, and neither does anyone else. And don’t put all your portfolio in it either — they’re not for the faint hearted.