Most UK smaller company funds outdo passive

We explain why active fund managers face better odds of outperforming passive by investing in small-caps.

Most UK smaller company funds have added value for investors by outperforming their passive counterparts over the past five years. Research from Albemarle Street Partners found that 97.7% of active fund assets in the Investment Association’s (IA) UK Smaller Companies sector had outperformed passive over that time period.

Another highly consistent sector was IA UK Equity Income, in which 91.9% of active fund assets outperformed. The sector remains deeply out of favour with investors, despite the dividend recovery that is taking place.

In third place was IA European Smaller Companies, with just over three-quarters of active fund assets (76.2%) outperforming passive.

Of the remaining eight sectors Albemarle Street Partners examined, the odds of investors outperforming passive for three of the sectors - IA Global Emerging Markets (57.9%), IA UK All Companies (57.5%) and IA Japan (55.8%) - was slightly greater than a toss of a coin.

Most active fund assets underperformed their passive counterparts in the other five sectors: IA North America (32.6%); IA Europe excluding UK (33.9%); IA Global (36.8%); IA Asia Pacific Excluding Japan (39.1%); and IA North American Smaller Companies (40%).

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Why there’s greater active success with smaller companies

Active fund managers face better odds of outperforming a passive fund when they invest in smaller company shares. Smaller companies are less covered by analysts, meaning there is more chance of an active manager who invests exclusively in smaller companies gaining an edge by finding underpriced shares.

In contrast, larger companies are widely researched and followed by analysts, so it is harder for active fund managers to find hidden treasures among their investment universe, meaning they are less likely to get ahead of an index fund or exchange-traded fund (ETF) investing in larger companies.

Over the long term, smaller companies have historically outperformed larger companies. To borrow a quote from the late Jim Slater, ‘elephants don’t gallop’. In other words, smaller companies have more room to grow and greater ability to potentially produce higher returns for shareholders.

The trade-off is that smaller companies can be more volatile than their blue-chip counterparts.

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US market a tough nut to crack for active funds

Over the years, plenty of column inches have been devoted to observing that the US market is a tough nut for fund managers to crack in terms of delivering outperformance above and beyond the S&P 500. It is the world’s most widely researched and followed index, which makes it difficult for fund managers to gain an edge.

As the research from Albemarle Street Partners shows, active US funds investing in smaller companies have also struggled to outperform passive over the past five years. Smaller company indices give greater sector diversification, with less tech exposure (compared to the S&P 500) and much more exposure to less popular sectors such as industrials, real estate and consumer discretionary.

There are other factors at play, one of which is costs, which are a drag on performance and compound over time.

The cheapest exchange-traded fund (ETF) tracking the fortunes of the S&P 500 is the Invesco S&P 500 ETF (LSE: SPXP), which is just 0.05% a year. Active funds, however, tend to charge 0.85% a year. The gap between the two needs to be overcome by the active fund manager, otherwise investors are better off simply tracking the market. 

For the smaller company-focused Russell 2000 Index, the cheapest ETFs are the SPDR® Russell 2000 US Small Cap ETF (LSE:R2SC) and the Xtrackers Russell 2000 ETF (LSE:XRSG), both of which charge 0.3%.