UK smaller companies funds: growth, risk & how to choose

UK small-cap funds often invest in exciting, innovative companies at an earlier stage in their development that are expected to grow rapidly. But this potential comes with a health warning: such stocks are more unpredictable and are likely to take investors on a more volatile journey

On this page, we explain everything you need to know about the sector and how to find the best UK smaller companies funds for your portfolio.

UK smaller companies funds: growth, risk & how to choose

UK small-cap funds often invest in exciting, innovative companies at an earlier stage in their development that are expected to grow rapidly. But this potential comes with a health warning: such stocks are more unpredictable and are likely to take investors on a more volatile journey

On this page, we explain everything you need to know about the sector and how to find the best UK smaller companies funds for your portfolio.

• UK small-cap funds invest in listed companies with lower market capitalisations
• These businesses have higher growth potential, but can be more volatile than larger companies
• Micro cap funds invest in listed firms with the smallest market caps
• FundCalibre can help you find the best UK smaller companies funds

What are UK smaller companies funds?

They are funds that invest in companies with relatively low stock market valuations, especially compared with the FTSE 100 giants. The best UK smaller companies funds will identify undervalued businesses with strong management teams and scalable operations. They will generally focus on companies in the FTSE Small Cap index, alongside smaller businesses within the FTSE 250 and those listed on the Alternative Investment Market (AIM), with true small-cap exposure often more precisely captured by the Numis Smaller Companies Index. According to the Investment Association, UK small-cap funds must invest at least 80% of their assets in UK equities of companies that form the smallest 15% by market capitalisation.

The case for UK smaller companies: why investors look here

When you put your money into UK small-cap funds you are buying potential. The businesses they focus on will have the potential to enjoy faster growth. This can be due to factors such as new product ranges they’re developing, international expansion plans, and their ability to disrupt the industry. The hope is that the market has overlooked these qualities and that investors will benefit from significant share price increases once they’re acknowledged.

The risks you need to understand before investing

Higher volatility

Smaller companies tend to endure large share price swings. Investors in this area must have a time horizon of at least five years to ride out this volatility.

Liquidity risk

Shares in such businesses also tend to be traded less frequently. This means there are fewer potential buyers, making it harder to sell the stock during tougher periods. When you’re looking for the best UK small company funds, it’s important to know which businesses they’re investing in and whether liquidity could be an issue.

Information and research risk

Fewer analysts tend to cover these stocks, so there won’t be as much publicly available information on them as on the larger-cap names. They may also not produce as much data. However, this provides more opportunities for active fund managers to conduct their own analysis and uncover hidden value in such businesses.

Concentration risk

Some UK small-cap funds may hold relatively few positions. This can inadvertently mean a higher concentration risk in a handful of sectors. Would-be investors must pay attention to how many stocks it holds and what percentage of its assets under management is allocated to the 10 largest names.

Sector-level risks

UK small-cap funds may have significant exposure to a relative handful of sectors, depending on the companies in which they’ve chosen to invest. This can potentially leave them vulnerable to shocks. For example, if they are heavily weighted towards tech names, they can be disproportionately affected by a downturn in this area.

Why active management matters more in this sector

There is more potential for managers of the best UK smaller companies funds to make their mark by finding relatively unknown businesses with huge potential.

Basically, smaller companies have:

• Less analyst coverage
• Lower institutional ownership
• Less media attention

Types of UK smaller companies funds

UK small-cap funds are not all the same. They will differ in structure, the companies they hold and sector allocations.

UK smaller companies (standard)

This is probably the largest sub-category. Typically, they will include FTSE Small Cap companies, those at the lower end of the FTSE 250 and AIM-listed stocks.

UK micro-cap funds

These are the very smallest listed businesses. Generally, this means market capitalisations of below £250 million as they will be at a very early stage in their development.

UK smaller companies investment trusts

Investment trusts are closed-ended companies that are themselves listed on stock markets. One advantage is that managers won’t be forced to sell holdings should investors want to make withdrawals, which is especially helpful in the smaller companies space where liquidity can be tighter. They also have the ability to use gearing, which can amplify returns in stronger markets. The trade-off is that they can trade at a discount or premium to their underlying assets, and their share prices can be more volatile than large-cap investments.

How to choose a UK smaller companies fund

Here is our guide to finding the best UK smaller companies funds to meet your needs:

Assess the manager’s track record and research process

The fund manager will play a crucial role in finding, assessing and choosing the most suitable companies for their portfolio, so be clear on their investment process. Look to see if they have a decent track record of delivering outperformance in different market conditions and whether they have any risk controls in place.

Check the fund’s size focus

What size companies does the fund favour? Does it mainly consist of small-cap names or is it more heavily weighted towards the micro-caps?

Consider the investment style

Get a feel for how they run the portfolio. For example, are they growth or value investors? Do they favour businesses that are recovering or those growing at a reasonable price

Check costs

The charges levied by UK small-cap funds can vary, so you must be clear on what costs apply and how they’re likely to affect your returns. You should pay particular attention to the Ongoing Charge Figure (OCF), which is a percentage representing a fund’s annual operating costs. The best UK smaller companies funds will strike the right balance between performance and fees.

Where do UK smaller companies funds fit in a portfolio?

This will depend on your investment goals, attitude to risk and existing holdings. Our guide on how to build your investment portfolio explains how different fund types can work together. As a result, the exposure to UK small-cap funds will generally be between 5% and 10% of an overall portfolio. They will typically sit alongside broader UK equity options, such as UK All Companies funds, or more income-focused strategies such as UK Equity Income funds.

Our process & how we select UK smaller companies funds

FundCalibre’s experts put together their UK smaller companies funds ranking based on a variety of financial factors. Only the very best are awarded a a prestigious Elite Rating. The process starts with AlphaQuest, our proprietary quantitative screening tool that estimates the likelihood that a fund manager will deliver superior returns. UK small-cap funds passing this test will be quizzed on their investment philosophy and approach to portfolio construction. This analysis will be subject to peer review before a decision is made.

FAQs about UK smaller companies funds