The post-Brexit bounce plus an uptick in M&A activity helped make UK Smaller Companies the most profitable fund sector.
In the two years since the Brexit vote, small companies have been the most profitable place to invest within the UK economy.
While the FTSE 100 index returned 31.4 per cent over that time period, the FTSE Small Cap index managed 38.3 per cent.
Likewise, when it came to active management UK small companies also cleaned up. Funds in the Investment Association’s UK smaller companies sector saw an average return of 48.6 per cent; by contrast, the IA’s UK all companies sector returned 30.6 per cent.
Several factors are behind this strong performance.
UK smaller company equities and funds were hit hard, both in the build-up to and in the initial fallout from the referendum. Being more domestically focused, many UK small companies funds were dumped over fears that Brexit would cause major economic disruption.
As Darius McDermott, managing director of Chelsea Financial Services notes, ‘Small caps were in fact beaten up in the run-up to the referendum and, at one point, were sitting at a hefty 20 per cent discount relative to the FTSE 100.’
Major disruption may of course still be awaiting the UK. However, in the absence of any immediate economic shocks following the referendum, investors’ nerves calmed, leading many to conclude that smaller companies were undervalued and offered good buying opportunity. McDermott adds: ‘When investors realised that the UK economy may not be doomed after all, this discount shrank (it is around 10 per cent today) as they snapped up the stocks which had unfairly been tossed in the bargain bin.’
At the same time, the post-Brexit sell-off of the pound made UK companies more attractive to overseas buyers, leading to an uptick in M&A activity from abroad. With acquisitions typically lifting share prices, UK smaller company stocks – and the funds investing in them – saw strong performance, as shown below.
Top 10 UK equity funds since EU referendum
*Source: FE Analytics, total returns in sterling, 23 June 2016 to 13 June 2018.
However, despite the strong performance of UK smaller companies, European smaller companies comfortably kept pace with them. As the table below shows, average returns from the IA’s European smaller companies sector were 48.8 per cent, marginally above UK smaller companies.
UK and European fund sector averages since EU referendum
Whether or not UK Smaller Companies will be able to keep up this strong performance is yet to be seen.
While a date has been set for the UK’s departure from the EU, no coherent agreement for that departure has yet been agreed. Such an agreement is expected, at the earliest, towards the end of 2018, just months before the date when the UK is supposed to leave - 29 March 2019.
If it appears that a bad deal or even no deal is on the cards, the fears that initially pushed UK smaller companies into their previous steep discount may once again return.
‘For now, and for at least over the medium term, the key will be to keep calm and carry on, making sure your portfolio is well-diversified,’ suggests McDermott.