Navigating the dilemma of small vs large-cap funds for your ISA

When constructing a diversified portfolio, the decision on how much to invest in small and large-cap equities becomes pivotal. This choice often revolves around the trade-off between seeking security or aiming for growth.

Market capitalisation, commonly known as market cap, represents the total value of a company’s shares. Small-cap companies are characterised by their smaller size, while large-cap companies, exemplified by giants like Shell – the largest company on the UK stock market – boast significant market value.

Discover the pros and cons

The past decade witnessed small-caps outshining, however, the journey for small-cap investors is marked by periods of volatility and liquidity challenges, as seen during the credit crunch.

In the past two years, larger companies have taken the lead, outpacing their smaller counterparts globally. Investors gravitated towards safety and predictability during uncertain economic times. The ongoing debate between small and large companies revolves around the trade-off between faster growth and periodic, painful falls.

Ultimately both offer advantages to investors, here are a few pros and cons of each:

Large Companies

Pros

• • Stability: Large companies are often well-established with a history of stability, making them less prone to abrupt market fluctuations.
  • Dividends: Many large-cap stocks offer dividends, providing a steady income stream for investors, particularly appealing in low-interest rate environments.
  • Global Recognition: Large-cap companies are often globally recognised brands, contributing to investor confidence.
  • Analyst Coverage: Typically, large-cap stocks receive more extensive analyst coverage, providing investors with a wealth of information for decision-making.

Cons

• • Limited Growth Potential: Large-cap stocks may have limited growth potential compared with their smaller counterparts.
  • Slower Adaptation: Due to their size, large companies may be slower to adapt to changes, hindering agility in dynamic market conditions.
  • Bureaucracy: Larger organisations may suffer from bureaucratic inefficiencies, potentially impacting decision-making speed.

Small Companies

Pros

• • High Growth Potential: Small companies often have more room for growth, with the potential to outperform larger peers.
  • Undervalued Opportunities: Lack of extensive analyst coverage may lead to undervalued opportunities, providing a chance for investors to discover hidden gems.
  • Agility: Smaller companies can adapt more quickly to changing market conditions, capitalising on emerging opportunities.
  • Market Niche: Small companies may dominate niche markets, allowing them to be leaders in specific industries.

Cons

• • Volatility: Small-cap stocks are generally more volatile, experiencing sharper price fluctuations than their larger counterparts.
  • Liquidity Concerns: Buying and selling small-cap stocks may be less straightforward due to lower liquidity, impacting transaction speed and costs.
  • Risk of Failure: Smaller companies have a higher risk of failure, particularly during economic downturns or industry-specific challenges.

Fund options for your ISA

Three large-cap funds

GQG Partners US Equity — This is an unconstrained, highly concentrated portfolio of just 15-40 large-cap companies in the United States. The focus is on forward-looking quality and sustainability of earnings growth, rather than companies that have simply done well historically. This view of quality allows them to strip away labels like value and growth in favour of long-term compounding.

Morgan Stanley Global Brands — As the name suggests, this fund targets well-known global brands, many of which investors will be familiar with on a day-to-day basis, such as Microsoft and Visa*. The fund is a very concentrated portfolio of high-quality global companies, with features such as strong network benefits and brands, or licences and permits that can provide an advantage over competitors. They will also look for companies benefiting from economies of scale and leading market distribution.

GAM Star Continental European Equity — This fund invests in large companies, with the team preferring those they believe will grow faster than the index. The team looks to buy stocks at the point where they are either out-of-favour or where growth prospects are believed not to be fully reflected in the share price. The fund has a low turnover and is not constrained by an index.

Three smaller cap funds

Liontrust UK Micro Cap — This fund looks to tap into early stage companies with the potential for significant growth. To do this, the five-strong team only invests in profitable companies, which also have at least one intangible asset – these include a strong distribution network, high recurring revenues, or a strong brand. Companies must also have an element of owner management to align their interests with shareholders.

T. Rowe Price US Smaller Companies Equity — This fund has a flexible approach. The manager looks for both growth and value opportunities in the small and mid-cap space, to build a diverse portfolio of the best ideas from the vast analyst resource at his disposal. The manager will allow his winners to run as long as he still believes there is a return opportunity. As such, the portfolio is likely to have more of a mid-cap bias than its peers.

The Global Smaller Companies Trust — This trust invests in smaller companies from around the world. Fund manager Peter Ewins believes that these businesses experience superior growth over the long term compared with larger companies. His goal is to go where other equity researchers won’t, in order to find hidden gems at attractive prices. The trust is one of the oldest in the market and has also successfully produced 50 years’ worth of dividend growth for investors.

Dive deeper into the opportunities available in global smaller companies in our recent insights.

*Source: fund factsheet, 31 December 2023