UK Smid managers come back fighting after being tarred by Brexit and Covid sell-off

UK equity funds with a small to mid-cap bent are finally experiencing a moment in the sun after years of being bogged down by Brexit and more recently by the Covid sell-off.

“Small cap has just had this continual run of bad luck over the last four or five years unfairly so,” says Fairview Investing consultant Ben Yearsley. “It’s been tarred with Brexit and then Covid.” 

Investors have pulled a total of £392m from UK Smaller Companies funds over the last 12 months, according to stats from the Investment Association. While UK All Companies funds have suffered more extreme bouts of redemptions, shedding £612m in February when the Covid crisis kicked off and a further £1bn in June and July, the sector still has net positive flows of £555m over the same period. 

Despite being unloved by investors, UK smaller companies funds have bounced back much better than their large-cap focused brethren since the market bottomed. 

Morningstar associate director of equity fund strategies Samuel Meakin notes the FTSE Small Cap ex Investment Trust index slightly trails the FTSE All Share year-to-date, down 18.2% against the latter’s 16.9% decline. 

But the reverse is true when looking at funds where the UK Small-Cap category has outperformed the UK Large-Cap Category “and by a wider margin”. 

UK small cap comes back fighting

Portfolio Adviser asked Morningstar to compile data on the 20 best-performing UK equity funds across all categories year-to-date.  

It found that 13 out of 20 funds, including nine of the top 10, had an explicit small-cap focus. The Miton UK Smaller Companies, run by Gervais Williams and Martin Turner, was the clear winner, returning an impressive 38.3% over the period, twice as high as the second-best performer MFM Techinvest Special Situations which rose 19.2%. 

By contrast, only three large-cap funds feature among the strongest performers so far, as well as three funds in Morningstar’s UK Flex-Cap Equity category. Only a single UK equity income fund, Miton Multi-Cap Income, featured among the top performers. 

Best performing UK equity funds year-to-date

Source: Morningstar; total returns calculated to 31 August 2020  

Lyxor ETF Asset Management’s latest Active–Passive Navigator report shows smaller companies had a better track record of navigating Covid-stricken markets over the first half of the year than their large cap counterparts.  

Around half (53%) of EU-domiciled active equity funds outperformed their respective benchmarks net of fees in H1. But when looking at active smaller companies funds in isolation the average outperformance shot up to 70%. UK Small Cap had the highest hit ratio of all equity funds at 76%, followed by Europe Small Cap with 75%. 

UK Smid less exposed to Covid-wrecked energy companies and banks

“Some of this performance will be a result of what these funds were not exposed to compared with what they are,” says Willis Owen head of personal investing Adrian Lowcock. 

“By having either no or little exposure to large companies they avoided some of the main areas which were impacted by the Covid-19 crisis such as oil, airlines and travel companies.  

“While Smid funds can invest in these areas, such funds tend to be well diversified to reduce the risk of investing in Smid companies and the focus of most managers in this space tends to be on growth over value.”  

SDL Free Spirit manager Andrew Vaughan (pictured) told Portfolio Adviser he avoids energy companies and financials altogether. His £21.6m fund, which sits in the Investment Association’s UK All Companies sector, has returned 2.2% compared with the sector’s losses of 17% and is the top performer year-to-date.

At the end of August a third of Vaughan’s portfolio was in companies with a market cap between £100m and £500m compared with 18.8% in businesses valued at £5bn and above. 

Top UK multi-cap funds exploiting Smid bias

The next best funds in the IA UK All Companies sector – the Marlborough Multi-Cap fund and Baillie Gifford UK Equity Focus funds – also have a bias toward small and mid-cap companies.

Richard Hallett’s Marlborough Multi-Cap Growth fund, which has outperformed the sector average by 17.8%, had 38.3% in medium sized companies and 11.1% in small cap at the end of August compared with 21.6% and 25.1% in large and mega caps. 

Baillie Gifford does not provide market cap breakdowns for its funds, but UK Equity Focus fund’s investment objective states it has a focus on small and mid-sized companies.

Director of marketing and distribution James Budden says managers care more about companies’ growth prospects than their size when hunting for UK stock picks. 

“Some small and medium size companies might fit the bill, but they have to have the potential to grow over time,” Budden explains.  “Rightmove, Ocado and Hargreaves Lansdown all started small and made it big. But the truth is that the majority of small companies stay small for a reason and it is not our style to trade in and out of them on valuation grounds.” 

Vaughan says he has been finding opportunities across the market cap spectrum, adding to existing positions in FTSE 250 defence company Avon Rubber and FTSE 100 software firm Aveva, as well as initiating a stake in flavour and fragrance supplier Treatt, which sits in the FTSE Small Cap Index.  

Tapping into tech and video games

Many of the top performing managers this year have been tapping into tech and stay-at-home stock trends which are underrepresented in more mature indices like the FTSE 100. 

Kainos, which provides software and consulting services to the UK government, is one of her top performers year-to-date with shares up 30% as is video game company Team 17 which has seen its shares spike 80% over the lockdown period. They are currently the second and third largest holdings in Jackson’s portfolio at 3.3% and 2.9% respectively. 

“People see the UK market as sometimes a bit staid and lacking in these really brilliant sorts of companies that the US is full of,” she says. “But there is lots of tech in the UK, it’s just not in the FTSE yet.” 

Hallett’s strongest performers include Aim-listed Gamma Communications which provides communication, mobile and connectivity services for businesses, as well as animal genetics company Genus.

He has participated in several fundraisings for mid-sized digital businesses over the summer, including online payments company Network International and Martin Sorrell’s latest venture S4 Capital, which he initiated a stake in at the time of its placing in July.

“There have been a number of fundraisings by companies that fit our demanding criteria and that have been raising cash not because they need it to weather the storm, but because they’re looking to acquire competitors and strengthen their competitive position,” he says. “That has created a number of interesting opportunities and we’ve been happy to support several of these placings.”

Can Smid survive a no-deal Brexit?

But the UK Smid sector faces its share of headwinds, not least of all the ongoing Brexit uncertainty. 

Sterling weakness on the back of bad Brexit news has provided a tailwind to companies that earn a significant chunk of their revenues overseas, which tend to be large-cap names, Meakin says.  

“While a no-deal Brexit has the potential to produce a similar relative effect, there are also other implications to consider in the absence of a deal, which could vary by company and industry.” 

Hallett says a negative outcome from the Brexit negotiations poses an additional risk for the economy on top of navigating a recovery from the pandemic. But he stresses 80% of the total earnings of his portfolio companies are generated overseas. “So, while we’re investing in UK-listed companies, we’re not reliant on the UK economy.” 

Higher interest rates would also pose a challenge to UK Smid funds, says Lowckock, but adds “that seems a long way off from where we are today”.