Small can be beautiful but may not be reliable

Many smaller companies funds have lately enjoyed spectacular performance but can they maintain this success?

ISA investors who ignored the major players and invested their money in smaller UK companies over the last 18 months, will have learned that small can be beautiful.

ISA investors who ignored the major players and invested their money in smaller UK companies over the last 18 months, will have learned that small can be beautiful.

Smaller company funds have lately delivered the sort of growth you used to expect from the FTSE 100. The sector performed strongly in 1999 and the first three months of this year. During this time some funds doubled in value.

This success was partly because many small companies are young, expanding computer software and internet businesses, and benefited from the soaring valuation put on technology stocks up to March 2000.

Some inevitably struggled after tech stocks dipped in April, but over the last 12 months many investment funds specialising in smaller companies have nevertheless enjoyed spectacular performance.

Artemis UK Smaller Companies fund grew 183 per cent and Gartmore UK & Irish Smaller Companies 100 per cent over the 12 months to September 18, according to Micropal. Many other smaller company funds available to ISA investors have performed strongly (see table).

Craig Wetton, chief executive at Chartwell Investment Management, says smaller companies fell out of favour in the late 1990s as blue-chip FTSE 100 companies stormed ahead. "Even some fantastic small companies used to struggle to get investment because the sector was unfashionable. Share prices were often low and did not reflect the true value of many companies, but that has now changed. Now it is the bigger companies that are considered undervalued," he says.

Smaller companies may not suit investors who want a steady, reliable return. "If there is a major stock market correction smaller companies will be among the first to suffer. They may have brought nothing to market or have little track record, and will lose out when investors get nervous. They will also be the last to recover when the economy picks up," Mr Wetton says.

Another reason for their volatility is their heavy bias towards technology. Although few doubt that in the long term technology companies are set to deliver excellent growth, in the short term the going will get sticky at times, and some companies will fall by the wayside.

Mr Wetton's preferred funds include Britannic Smaller Companies, which grew 81 per cent over the last three years, and BWD UK Smaller Companies, which managed a storming 190 per cent over the same period. He also warms to Henderson UK Smaller Companies and Schroder UK Smaller Companies, which grew 155 per cent and 120 per cent respectively over the last three years.

John Beale, investment expert at discount house TQ Direct Choice, is confident smaller companies can maintain their recent success. "The sector has caught up dramatically with larger companies, and there is no reason why it should not sustain its current impressive performance."

He also recommends the BWD fund, "a top quartile fund over one, three and five years". For investors interested in slightly larger companies, he recommends the Dresdner RCM UK Mid Cap, which invests in the 250 largest companies outside the FTSE 100.

James Dalby, investment adviser at Bates Investment Services, warns ISA investors that while smaller companies may be enjoying their day in the sun today, larger companies may have their turn tomorrow. "You should be looking to build a balanced portfolio covering a range of sectors."

He says investors with larger portfolios should not restrict themselves to UK smaller companies and suggests European smaller companies as a good place to start, particularly Invesco GT European Growth, which grew 209 per cent over the last three years.

Mr Dalby adds: "The US is the world's largest market and although companies are not cheaply valued there are so many opportunities that a good active fund manager will find some real gems." He recommends Henderson American Smaller Companies, which has grown 124 per cent over the last three years. For a smaller companies ISA with an international flavour he recommends investment trust Henderson Strata by Henderson Investors.

Some Japanese smaller companies funds have performed well recently, but Mr Dalby says: "I would stay away from Japan unless you are really well represented in other areas. There is a recovery underway but it is very fragile."

To underline his point, Threadneedle Japan Smaller Companies grew 219 per cent over the last two years, but little of that growth came in the last 12 months, when it managed just 7.5 per cent.