The Briefing: UK Smaller Companies

Anyone invested in a UK Smaller Companies fund would have been cracking open the champagne at the end of 2013 after a remarkably good couple of years. Constantly improving economic news had been helping small firms enjoy annual share price growth of around 30%.

A quick look at the statistics illustrates the point with the IMA UK Smaller Companies having been the best performing sector over one, three and five years, according to figures compiled by Morningstar to 4 August 2014.

However, the past few months have been a different story. Investors have found it much harder to make money from the area this year, with some companies suffering quite severe share price drops after failing to maintain their rate of growth.

To find out about a fund investing primarily in a portfolio of UK smaller companies, read: Fund to watch: Old Mutual UK Smaller Companies.

Daniel Nickols, manager of the Old Mutual UK Smaller Companies fund, believes one reason for the falling share prices, which started in April, could be that the stockmarket is trying to anticipate when the first of the interest rate rises will be, both here and abroad.

Is this the right sector for me?

Consider investing in this sector if...

• you want a concentrated exposure to small companies
• you have a longer-term investment horizon
• you want to be backing the next potential Microsoft

"The key risk facing stocks and shares currently is that if the authorities, such as the Bank of England, raise interest rates too quickly they risk slowing down the rate of growth in the economy," he says.

"Similarly, keeping interest rates permanently low might mean increased demand for goods and services, which could, in turn, push up consumer prices and lead to higher inflation."

There is, he suggests, a "middle way", where economic growth is neither too fast nor too slow and that inflation remains under control. "Nevertheless, investors are likely to adopt a 'wait and see' approach until they get a better handle on the likely magnitude of interest rate rises," he adds.

So where does that leave the investor? Should they continue to plough money into the sector despite its current wobble or take the view that the good days are over for now and turn their attention to other areas of the market?

Let's take a look at the sector itself. IMA UK Smaller Companies is for funds that invest at least 80% of their assets in UK equities of companies that form the bottom 10% by market capitalisation. There are similar sectors for North American smaller companies and for those across Europe.

By their very definition, the smaller companies these funds invest in are at an earlier stage in their growth so their cash flows and business structures are less developed. As a result, their earnings profiles are likely to be a lot more erratic and this can have a detrimental impact on share prices.

It's also worth remembering that performances are likely to vary wildly in this area of the market, points out Geoff Penrice, a chartered financial planner at Astute Financial Management, who argues there is a correlation between the level of risk taken and the potential for reward.

"Poorly performing small companies will do really badly," he says. "However, if you pick the right ones you can get a much higher return than you would receive from larger companies. The higher the investor's appetite for risk, the higher the proportion they would hold in smaller companies."

There isn't a benchmark that can realistically be closely tracked, so each stock in a fund should be there as the result of a conscious decision from the manager"Patrick Connolly

Unlike some sectors, therefore, investing in UK smaller companies is all about the stockpicking abilities of the fund manager and that's why picking the right one is absolutely vital, according to Patrick Connolly, a certified financial planner at Chase de Vere.

"There isn't a benchmark that can realistically be closely tracked, so each stock in a fund should be there as the result of a conscious decision from the manager," he says. "Investors should be looking for experienced managers and investment teams that have shown they can find opportunities that others might miss and have a proven record of long-term outperformance."

A quick look at the largest shareholdings of the top-performing Fidelity UK Smaller Companies fund shows a number of companies most beginner investors will have never heard of, including Lavendon Group and UDG Healthcare. Similarly, at Schroder UK Dynamic Smaller Companies fund, the top five shareholdings include Smart Metering Systems and Stock Spirits Group (STCK). These are stocks that beginners would be unlikely to stumble on themselves.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.