UK small-cap funds have seen their performance bounce after Brexit, as the country’s minnow stocks gained unexpected popularity.
Morningstar’s UK small-cap sector funds recorded two months of unusually strong performance following the UK’s vote to leave the EU, including the highest monthly sector return since December 2010 in July.
The sector recorded its highest monthly total return figure for nearly six years in July, giving investors a 7.5 per cent return followed by 5.2 per cent in August. The FTSE SmallCap index returned 7 per cent and 2.8 per cent in the same months.
The bounce follows a run of woeful performance from the sector. For the one-year period from May 2015 the sector has returned an average of 0.6 per cent a month.
The most popular funds in the sector include Standard Life’s Smaller Companies, Marlborough Special Situations, Old Mutual UK Smaller Companies and Liontrust UK Smaller Companies.
Fund performance has been buoyed by a recent rally in the FTSE SmallCap index, which had a record run of closes last month as the prices of smaller minerals, resources and energy companies were bid up.
With a rise of 5.8 per cent in the value of the index this year, the performance of the FTSE’s small companies have outperformed the FTSE 250 — which has climbed 3 per cent — but has still underperformed the large-cap FTSE 100, which has climbed 11 per cent over the same period.
Despite this, UK small-cap funds have been unpopular with investors this year; most larger vehicles have seen net outflows in the year to date and eight of the ten largest funds saw net outflows in July.
“Ahead of Brexit people started selling the FTSE 250 and they started selling the small-cap names,” said Michelle McGrade, chief investment officer at broker TD Direct Investing. “The trade was to sell the FTSE 250 and buy the FTSE 100”.
Samuel Meakin, small-cap analyst at Morningstar, said small-caps have recovered well from “indiscriminate selling” of mid and small-cap stocks in the immediate aftermath of the Brexit vote.
Investors looking to buy into small-cap funds may nevertheless hit problems, since funds investing in small-caps tend to be averse to large inflows.
As they invest in companies with small market capitalisations, they are unable to pour large sums of money into single stocks without owning a much larger proportion of the company, which can threaten their ability to sell their positions in future.
Standard Life, Fidelity International and River and Mercantile are among the asset managers to have “soft closed” their small-cap funds.
“Each manager wants to be as small as possible in terms of size because it allows them to be more nimble,” said Ms McGrade.
There are only two funds with more than £1bn in assets under management — Standard Life’s UK Smaller Companies and Marlborough’s Special Situations.
“If funds get much larger [than £1bn] they would have to start going into mid-caps and they don’t want to do that,” said Ms McGrade.
At least three of the funds among the top ten are soft closed, meaning they will not accept money from new clients. Some of the funds count retail brokers such as Hargreaves Lansdown or TD Direct as one customer and so accept new flows from individuals buying through brokers.
“When fund houses tell us they’re soft closing it usually just means they’ve stopped marketing the fund,” said Mr Meakin.
Jake Moeller, analyst at Lipper, said fund houses were becoming “more proactive” about soft closing funds. “Traditionally, UK small-cap funds have always been most susceptible to capacity constraints, especially since they offer more alpha opportunities when their coverage is low.”
“£500m is generally an upper limit, but some managers are comfortable managing more — there is no precise science to capacity.”
But Paras Anand, head of European equities at Fidelity International, which soft closed its small-cap fund in April, said it was difficult to predict whether flows into the funds would follow performance.
“Generally, customers are driven towards small-caps by the UK economy doing quite well,” he said.
“Common sense would say an insufficient amount of time has passed for people to have a clear sense of the domestic demand picture over the next few years.”
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