When we invest, the fixed interest portion of our portfolios is there to mitigate the risk that the stock market brings: the market is our returns engine and the fixed income is our risk-diluter.
But within the market there are different sub-sectors – such as the location, size and value of the companies in which you’re investing. The relative size of the companies in which you invest has a considerable effect on your portfolio’s performance.
How much of an effect? Historically, a substantial one.
50 years of evidence
The UK small cap index (focused on companies with a market capitalisation up to $2bn) has on average returned over 17 per cent annually since 1983, and the international small cap index also did very well at almost 16.5 per cent per year average return.
In fact, a £10,000 investment in the UK small cap index in 1983 would be worth over £591,000 today; and the international small cap would have returned £493,000.
That contrasts with the FTSE All-share index performance, at a much more modest £318,000 over the same timeframe.
Looking even further back, the following graph charts different markets between 1956 and 2016, measuring the returns on £1 invested in 1956 (click to enlarge):
Years and years of research shows there is a small cap premium: the returns are higher compared to the general market when investing in smaller companies. That’s because the risk associated with smaller companies is higher, because larger companies are generally much less likely to go bust or insolvent.
And because the risks and rewards are greater, so is the volatility; there’s a larger potential downside, more risk of your investment going down and not up. If you invested solely in small cap, although you might get a better return, the swings would be more than most could comfortably handle.
The small cap premium doesn’t appear every single year; it’s frequent, but not annual. The goal then is to take advantage of the premium returns, without exacerbating risk beyond reasonable levels. At Lexo, that’s why we have tilts, or overweights, in our portfolios of around 20% towards small cap, rather than being purely small cap.
There are two very important things to remember when it comes to small cap investing – they apply to ALL investing, but particularly here:
Diversification is how we manage the risk involved in small cap premiums. The premium is evident in all countries, not just the UK and US, and we capture that globally at Lexo by investing across all markets – emerging, Asian and so on. It’s one reason why our portfolios are spread across over 10,000 holdings, not just several hundred as is typical elsewhere. As investors, if we didn’t have a broad diversification in our portfolio, the effect of one of those small cap companies going under could be substantial; but by having holdings in thousands of companies, we mitigate this risk.
Some years, the small cap premiums are very small. So you must ensure you’re paying the lowest possible fees to maximise your returns. Fees are really important in your investment results, so be clear on what your provider charges. At Lexo we believe strongly in complete transparency on fees, which you can find here.