The UK small-cap sector represents a distinct asset class that many advisers have reduced exposure to in recent years.
Understanding the characteristics, risks, and structural considerations of small-cap investing through investment trusts is essential for advisers making informed allocation decisions for their clients.
Current valuation context
UK small-cap equities are currently trading at a significant valuation discount relative to large-cap stocks. Several structural factors have contributed to this positioning: reduced post-Brexit foreign investment flows, declining sell-side analyst coverage of smaller companies, and a general shift in institutional capital toward larger, more liquid securities and international markets.
These valuation levels create specific considerations for advisers. Lower valuations may indicate either genuine risk factors that justify discounted prices, or potential mispricing where market sentiment has diverged from underlying business fundamentals. Distinguishing between these scenarios requires careful analysis of individual company quality, sector dynamics, and the reasons behind market pricing.
Understanding why valuations stand at current levels helps advisers assess whether small-cap exposure aligns with their clients’ risk tolerance and investment. Valuation starting points historically have been significant determinants of subsequent returns, though they provide limited information about timing.
Historical performance characteristics
Long-term market data shows that small-cap equities have typically delivered higher returns than large and mid-cap stocks over extended periods, though with notably higher volatility. This pattern, often termed the “size premium”, has been documented across multiple markets and time periods.
Several factors may explain this historical pattern. Smaller companies often have greater proportional growth potential, as doubling revenue or market capitalisation represents a more achievable absolute figure than for established large caps. They may also be less efficiently priced due to limited analyst coverage and institutional participation.
However, advisers should note important caveats. The size premium is not consistent across all time periods there have been extended phases where large-caps outperformed. The premium varies significantly by market conditions, economic cycles, and geographic markets. Higher average returns come with higher volatility and greater dispersion of outcomes between individual securities.
Over the long term and in every decade until 2020, returns from UK small-cap equities have also exceeded inflation, notably significantly during the 1970s. Unusually, since 2020 returns from UK small cap equities have been underperforming inflation. This looks anomalous and we believe is another signal that the asset class has the potential to offer strong long term returns from this point.
For client portfolios, this means small-cap exposure should be considered within the context of overall asset allocation, risk capacity, and time horizon rather than as a standalone decision.
Corporate activity
Smaller quoted companies are statistically more likely to be acquired than larger ones. This occurs for several reasons: they represent manageable acquisition sizes for corporate buyers and private equity firms, they may offer niche capabilities or market positions that strategic buyers value, and their lower absolute valuations can make takeover financing more feasible.
Takeover activity can significantly impact returns for small-cap investors. Acquisitions typically occur at premiums to prevailing market prices, sometimes substantially so.
However, advisers should understand that takeover potential should not be a primary investment rationale. Acquisitions are unpredictable in timing and occurrence, and companies trading at depressed valuations may remain so for extended periods without corporate interest.
Structural differences
The vehicle through which small-cap exposure is accessed has significant implications, particularly regarding liquidity management.
Open-ended funds must maintain sufficient liquidity to meet investor redemptions. When investors withdraw capital, fund managers must sell holdings to return cash. In small-cap portfolios where individual securities may trade infrequently, this creates a structural tension between holding the most attractive opportunities and maintaining adequate liquidity.
During periods of market stress or fund outflows, managers may be forced to sell positions at disadvantageous prices or maintain larger cash balances that drag on performance.
Investment trusts, being closed-ended structures, face no redemption requirements. The fixed capital base means managers can take positions in less liquid securities without needing to consider redemption scenarios. This allows for higher conviction positioning in less liquid stocks, no need to maintain cash buffers for redemptions, and the ability to take genuinely long-term positions through periods of market volatility.
Investment trusts can also employ gearing (borrowing to invest), typically up to 20% of assets, which amplifies both gains and losses. This leverage is not available to open-ended funds and introduces an additional risk and return consideration.
A fundamental difference lies in pricing mechanisms. Open-ended funds are priced at net asset value (NAV), with investors buying and selling at the value of underlying holdings.
Investment trusts are publicly listed companies whose shares primarily trade on the London Stock Exchange, meaning their share prices can deviate from NAV, trading at either premiums or discounts. This creates both additional complexity and potential opportunity, as investment trust shares may be purchased below the value of underlying assets or sold above it.
Risk considerations
Small-cap investing involves specific risks that advisers must evaluate against client circumstances. Volatility is typically higher than for large-cap equities, with greater price fluctuations during market turbulence.
Liquidity is lower, meaning positions can be harder to exit quickly without price impact. Individual company risk is elevated, as smaller firms generally have less diversified operations, less financial resilience, and higher failure rates than established large-caps.
For investment trusts specifically, discount volatility adds another dimension. Trusts can see their discounts widen during market stress, amplifying losses beyond the underlying portfolio decline. Conversely, discount narrowing can enhance returns during recoveries.
These characteristics mean small-cap investment trusts are generally more suitable for investors with longer time horizons (typically five years plus), higher risk tolerance, and as part of a diversified portfolio rather than a concentrated holding.
Due diligence and portfolio application
When evaluating small-cap investment trusts, advisers should assess the manager’s experience and investment process, historical performance across different market conditions, the consistency of the discount or premium to NAV, discount control policies including periodic redemptions, daily liquidity, ongoing charges and their impact on net returns, and portfolio concentration levels.
The governance structure and the trust’s approach to gearing also warrant consideration.
Small-cap exposure through investment trusts represents a specific allocation decision within the equity portion of client portfolios. Its suitability depends on individual client factors including risk capacity, time horizon, need for liquidity and existing portfolio composition.
Stuart Widdowson is co-portfolio manager at Odyssean Investment Trust
