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This time last year I made a case for UK smaller companies funds, arguing that they have, on average, outperformed UK All Companies in 12 out of the past 20 years. Well, you can now make that 11 out of the past 20, as they underperformed UK large caps in 2024, in line with small caps internationally. It was the sector’s third consecutive year of underperformance.

This is reflected in the rather lacklustre three-year returns in the table below. And that’s just the top ten. The bottom funds have fallen by more than 36% over the period, and the average return is -20%.

In the fourth quarter of 2024, amid a narrowing global equity rally, small caps underperformed in most regions. This was a reversal from the third quarter’s stronger performance but in line with the trend over the year, as large caps dominated a momentum-driven market. And, let’s face it, this was characterised not simply large caps, but a handful of US mega-caps. The sharp reversal in small cap’s Q4 performance came within the context of a change in inflation expectations and bond market yield moves, which had a negative impact. Smaller companies are more vulnerable to higher rates, as they tend to be more leveraged. Their debt is also more likely to be either index linked or of a shorter duration, making it more challenging to ride out spikes in base rates, as anyone on a two or three-year mortgage will have realised over the past few years.

Unlike many sectors, where passives are high up the leader boards, offering a range of sector and factor exposures that propel them forwards when the winds blow the right way, UK smaller companies still looks to be the territory of the active manager. Of the table below, only one—the iShares MSCI UK Small Cap UCITS ETF—is a passive vehicle. That said, that this plain-vanilla ETF holds eight place over three years among a field of active managers demonstrates how hard it has to add value through stock-picking in the sector—and likely shows the corrosive effect of the higher fees that comes with active management.

The fact that there are so many ones and twos (the lowest rankings) in the Capital Preservation column of the table testifies to the volatility of the sector. Nevertheless, seven funds from last year’s table make it into our latest. In any sector, that’s unusual, let alone one as febrile as this, and is a credit to those managers who have clung on.

Should UK small cap investors therefore throw the towel in? The case for the sector remains, even if the immediate conditions that could catalyse a rebound—a strong UK economic recovery—seem a little remote at this point. One potential positive is that, in a world facing greater tariffs and general protectionism, smaller companies tend to be more domestically focused. That could be a benefit, although there are many provisos and quid pro quos to be added to this. For instance, tariffs likely stoke inflation, leading to higher rates: asmentioned, smaller companies are more rate sensitive.

Last time I wrote that, given valuation levels, this is a sector that could have considerable upside when it finds its footing. That day has clearly yet to come. But, by the time we have all noticed that it has, we will probably be looking at the best returns in the rear-view mirror. This is a sector that comes with a lot of volatility, but if you want exposure to domestic equities, then it’s likely worth putting some of that in the small cap bucket.

Table 1: Top-Performing UK Smaller Companies Funds Over Three Years (with a minimum five-year history)

(Click on image to enlarge)

All data as of December 31, 2024; Calculations in GBP

Source: LSEG Lipper

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