Investing in UK small caps with investment trusts

From the start of 2023 through to the middle of May, 11 bids for private companies listed on the London Stock Exchange (LSE) had taken place, with a combined value of £13bn.

None of these takeovers involved large caps. Instead they were smaller firms, trading further down the London Stock Exchange’s market cap range. This builds upon growing interest we’ve seen among private buyers for UK smaller companies over the past few years.

Although things cooled off last year, 2021 was a record year for private takeovers of firms listed on the LSE. And if dealmaking continues at its current pace this year, it’s plausible 2023 will supersede that record.

Regardless of whether or not that happens, the fact there is continued interest in UK smaller companies from private buyers is a sign they see value in them and that they’re worth investing in.

Why invest in UK smaller companies?

As with other markets, UK small caps tend to attract investors for a couple of key reasons. One is that they receive much less coverage from institutional investors.

For example, asset management group Marlborough Fund Managers found in 2019 that large cap UK stocks had more than 20 analysts on average covering them. By comparison, the stocks in their UK small cap portfolio averaged fewer than four.

The implication here is that there is much less information available on smaller UK companies. As a result, investors are better able, at least in theory, to exploit that information gap and see better returns, compared to large cap investors, who may struggle to get an informational edge on their peers.

The other key factor is size. Smaller companies have the potential to grow into large companies and deliver strong returns for investors in the process. In contrast, a large multinational may continue to deliver regular returns for investors but struggle to see the sort of growth that would deliver outsized returns.

Finally, UK small caps are spread across a wider set of sectors relative to large caps. For example, at the end of May 2023, less than 1% of the iShares Core FTSE 100 UCITS ETF was weighted to information technology. In contrast, the MSCI UK Small Cap had a nearly 7% weighting to the sector.

UK smaller companies returns

Of course, the two points above regarding research and prospective growth are arguably purely theoretical. Having an informational edge may not actually lead to better returns and many companies simply won’t grow to deliver better returns than their larger peers.

Those are both valid arguments to make. Some companies won’t perform well and having an informational edge may not lead to you seeing better returns.

However, over the long-term, UK smaller companies have tended to outperform their larger peers, suggesting that there is more than just theory to those arguments, even if they don’t apply to every small cap company.

For example, if you invested in the Numis UK Smaller Companies Index (ex-investment companies) at the start of 1955 up until the end of 2022, you would have seen annualised total returns of 14.2%. In contrast, the FTSE-All Share Index saw annualised total returns of 11.1% over the same period.

That holds up over the near term as well. In the 10 years to 06/06/2023, the Numis UK Smaller Companies Index (ex-investment companies) delivered annualised returns of 6.3%. In contrast, an index of the UK’s 100 largest companies would have delivered 5.8% over the same period.

How investment trusts can be useful to invest in UK smaller companies

Managing a sizeable portfolio of any kind is difficult. Undertaking research, monitoring positions and ensuring you are happy with weightings are just some of the things you have to do. This isn’t impossible to do alone but it does require a lot of legwork.

That is probably the simplest reason that some investors prefer to use investment trusts to invest in UK smaller companies. An investment trust is a managed fund that is listed on the London Stock Exchange. To invest in the fund, you simply buy its shares.

Beyond that practical reason, investment trusts appeal to investors for several other reasons. One is that managers can take an active approach to the market, meaning they try to only select the top performing companies and see better returns than the benchmark.

Investment trusts also tend to appeal to investors for a couple of specific reasons. One is that they have the ability to use gearing. This is where the managers borrow money to invest and enhance returns. This does work both ways, meaning gearing can result in outsized losses if managers make poor investments.

The other factor is the fact that trusts are exchange-traded. This means their shares can be bought and sold during normal market hours, which can make selling and disposing of holdings easier for investors.

UK smaller companies - investment trusts vs open-ended funds

This structure may also be part of the reason trusts in the Association of Investment Companies’ (AIC) UK Smaller Companies sector have outperformed their open-ended peers in the equivalent sector of the Investment Association.

The fact that investment trust shares are exchange-traded means the managers do not have to deal with inflows and outflows in the same way that open-ended funds do. In simpler terms, the trading of an investment trust’s shares does not have an impact on the assets under its management – the two are separate.

In contrast, open-ended funds manage the money that they receive from investors directly. This means that when investors take money out of the fund, the managers must have cash on hand to meet that demand. This can create a drag on performance as cash holdings are simply left uninvested.

For small caps specifically this can also create some risks. Small caps can be less liquid than their larger peers. If an open-ended fund sees a surge in demands for redemptions, that can mean they are forced to sell off assets. If those assets are illiquid, it can be difficult to sell, something that can lead to steep price drops or even an inability on the part of the fund to meet those redemptions.

Investment trusts are more immune from this process. Investors can sell and cause the trust’s shares to trade at a discount to the value of its investments. However, they would not be able to put the same sort of downward pressure on the trust’s holdings that investors in an open-ended fund can.