UK small-caps rebound: top funds and trusts to take advantage

After a sustained run of being out of favour, smaller UK companies are bouncing back. Over the past three months, the FTSE Small Cap index has returned 10%, compared with 3.5% for the FTSE 100 index, which tracks the largest 100 companies on the London Stock Exchange. Over six and 12 months, smaller companies have also returned more than their larger peers.

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The comeback is more extreme in the investment trust world, where wide discounts – which were in part caused by rising interest rates – are beginning to narrow as a result of rising trust share prices.

Over the past three months, the average UK Smaller Companies trust share price has risen 15.5%, compared with 12.5% for UK All Companies trusts.

The Association of Investment Companies (AIC) reports that the average UK Smaller Companies trust discount is now just under -8%, which is around half what it was just six months ago, according to investment analyst Stifel.

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While smaller companies have been lagging recently, over the long term they tend to perform better than larger peers.

Dundas Global Investors finds that over the last century, small-caps have outperformed their larger peers by 2.1% a year in the United States, and by 3.2% a year in the UK. But since 2011, global small-caps have underperformed by -1.3% a year.

Interest rates have been a key factor for the recent fortunes of UK smaller companies. Two reasons stand out. First is their link to the health of the UK economy, where smaller companies tend to operate. If rates are rising, it suggests the economy will slow, which could hit company earnings.

The other reason is that smaller companies tend to grow faster and therefore receive higher valuations from investors. When interest rates rise, however, investors normally focus their attention more on “jam today” shares, as returns from safe assets such as government bonds rise, and so they are prepared to pay less for companies whose profits will come in the future.

But with the Bank of England making its first interest rate cut in four years, from 5.25% to 5%, the tide could be turning for smaller companies.

We look at how different funds and investment trusts have performed, and where opportunities can still be found in UK small-caps.

The top small-cap funds and trusts

Data from FE Analytics for the past six months shows that a handful of investment trusts have delivered the best returns in the UK small-cap space.

The top trusts are Downing Strategic Micro-Cap Investment Trust (up 78% over six months to 1 August 2024); JPMorgan UK Small Cap Growth & Income (up 32%); Crystal Amber (up 31%) and Aberforth Smaller Companies Trust (up 28%).

Some open-ended funds, which do not benefit from a narrowing of discounts, also performed exceptionally well.

These include Schroder UK Smaller Companies (up 20.4%); Aberforth UK Small Companies (up 20%); Artemis UK Smaller Companies (up 20%) and Unicorn UK Smaller Companies (up 19%).

Darius McDermott, managing director at fund rating group FundCalibre, says building on this year’s positive momentum, he expects further gains for the sector.

“UK small-caps, in particular, present a compelling opportunity. Despite history suggesting that they considerably outperform large caps over the long term, especially in recovering markets, they still trade at compellingly low valuations,” he said.

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McDermott’s best fund ideas include Liontrust UK Smaller Companies, WS Amati UK Listed Smaller Companies, and Unicorn Smaller Companies.

There are two UK smaller company funds on interactive investor’s Super 60 list of investment ideas: Amati UK Listed Smaller Companies and investment trust Henderson Smaller Companies.

The Amati fund has around 45% invested in the Alternative Investment Market, which is home to many small UK companies. All new investment ideas for the fund sit in the “sweet spot” identified by management of between £250 million and £1 billion in market cap. The portfolio currently has a weighted average market cap of £793 million.

The fund lags its peers and benchmark over three and five years, but is ahead over 10 years, returning 128% compared with 97% for the UK Smaller Companies sector.

Henderson Smaller Companies has bounced back this year and is now on a –8% discount, about half what it was in the spring.

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Our fund analyst team likes this strategy because of its diversified portfolio, at over 100 companies, and because versus the benchmark there is a clear bias to growth factors, with underweights to commodity sectors and an overweight to information technology. Experienced investor Neil Hermon has managed the trust for more than two decades.  

The investment trust is ahead of peers and its benchmark over the past six months, and year, but lags over three years.

Has the rally still got legs?

While UK smaller companies have bounced back, they still trail larger UK companies over the past decade. Given that history shows smaller companies outperform larger companies in the UK over the long run, this could suggest a longer-term recovery, particularly due to the favourable economic backdrop of falling interest rates and inflation.

Georgina Brittain, manager of JPMorgan UK Small Cap Growth & Income, says now that interest rates have peaked and are beginning a gradual decline, this should boost small-caps further.

“With consumer confidence and business confidence on the up, small-caps offer an attractive opportunity for investors to generate higher returns over the long term. Small-caps are much more domestically focused than large-cap companies, providing exposure to the more positive economic signals that are now starting to come to the fore,” she said.

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She adds that small-cap companies are typically associated with growth, but current valuations in the UK mean there are many high-quality stocks also offering good value.

“Even within the undervalued UK market, small-caps are cheap relative to large caps, despite frequently being able to maintain their growth potential regardless of the economic backdrop,” she says.

Another optimist is Roland Arnold, manager of BlackRock Smaller Companies Trust, who says that valuations in the UK, and in particular the UK small and mid-cap sectors, are “about as attractive as we have ever seen”.

Meanwhile, his view is that the economic backdrop is improving as the UK economy returns to growth, unemployment remains low, company balance sheets are strong, and inflation is falling.

“This backdrop gives us confidence that the outlook for the businesses we invest in is broadly supportive for an earnings recovery,” Arnold said. 

Nevertheless, because discounts have already significantly narrowed on investment trusts, a lot of the optimism could already be in investment trust prices.

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Stifel found that Henderson Smaller Companies and BlackRock Smaller Companies were two UK small-cap trusts on “narrow” discounts. This is because their discounts are at their lowest point in the past six months, at –7% and –6% respectively.

Stifel explained: “Henderson Smaller Companies has seen a net asset value rise of 13% over the past three months and 16% over six months. The discount has narrowed to -7%, which is half the -14% peak it has traded on at times in the last six months.

“BlackRock Smaller Companies has seen a similar move, with the discount now -6%, which is also at the narrow end of its six-month range of -12% to -6%.”