Structural quirks in index construction and a long stretch of poor sentiment mean the recent underperformance of UK small‑cap funds should be taken “with a pinch of salt”, say fund managers and analysts — even as they concede the weakness has been real. According to the original Trustnet report, the IA UK Smaller Companies sector has lagged the Deutsche Numis Smaller Companies 1000 Excluding Investment Companies across multiple horizons, but experts argue the headline numbers overstate the problem because the universe being measured is not homogeneous and market conditions are beginning to shift. Financial‑press analysis also shows many UK small‑caps now trade at discounts to historical multiples and international peers, reinforcing the view that valuations are disconnected from fundamentals.

Jason Hollands, managing director at Evelyn Partners, told Trustnet that much of the apparent underperformance is down to differing exposures within the sector: active funds’ weightings in AIM and the inclusion of micro‑cap and mid‑cap holdings in the IA sector averages can skew results. He points out that averages are asset‑weighted, so a handful of very large funds can distort the picture. abrdn’s own recent chair’s statement, for example, discloses material mid‑cap exposure and highlights the extent to which portfolio positioning — not just stock selection — has driven relative returns in recent years. The implication is that comparing a sector average to a single index can be misleading unless the underlying baskets are aligned.

That divergence has been amplified by the wider macro environment. As Trustnet records, since 2022 investors have favoured large, cash‑generative multinational businesses — many domiciled in the FTSE 100 — amid high inflation, rising interest rates and geopolitical uncertainty. Market commentary points to strong corporate earnings, sector rotation into defensive areas and expectations of easier monetary policy as key drivers behind the FTSE 100’s rally, which in turn has sucked capital away from domestically focused smaller businesses. The result has been a sustained relative outperformance of large caps that helps explain some of the small‑cap shortfall.

Structural shifts in the market have compounded the headwinds. Research summarised by Morningstar shows that rising passive ownership can widen bid‑ask spreads, increase volatility and blunt firm‑specific price discovery — effects that are typically more acute in smaller, less liquid stocks. Fund managers quoted in the Trustnet piece say persistent outflows from UK equity funds since Brexit, and a general underweight by large institutional investors, have pushed valuations lower and discouraged listings. Independent analyses also flag a thinning small‑cap universe as takeovers and a lack of new IPOs remove stocks from indices, leaving fewer investible names and deeper discounts for those remaining.

London’s junior AIM market illustrates the point. Reuters reporting has documented accelerated departures from AIM, fewer new listings and a rise in takeover activity, and market participants attribute some of that decline to tax and regulatory changes that have eroded incentives to remain listed. The practical effect is a smaller, less liquid cohort of quoted small companies — a structural change that both intensifies price dislocations and, paradoxically, can create concentrated opportunities for active managers who remain committed to the space.

Several managers argue those dislocations are exactly what long‑term investors should watch for. Cassie Herlihy, co‑manager of the WS Gresham House UK Smaller Companies fund, told Trustnet that UK small‑caps have traded at a sustained discount since the Brexit vote and that the gap has widened in recent years amid consistent outflows — but she described that divergence as “providing an attractive buying opportunity for long‑term investors”. Other industry analysis similarly concludes that patient, selective investors may find value where headline indices and passive flows have left prices depressed. Trustnet also records early signs of improvement: a mid‑peer bounce in recent months and renewed institutional interest that managers describe as “green shoots”.

Caveats remain. Smaller companies’ low liquidity means inflows or even a stem in outflows can produce outsized moves — good and bad — and continued passive growth could prolong valuation distortions. Yet several industry voices now see a path to recovery: a rotation away from US‑centric themes as policy uncertainty mounts there, improving domestic economic indicators and a political tone more focused on growth have all been cited as potential catalysts. For investors, the message from managers and analysts is consistent — the headline underperformance needs context, and disciplined, value‑aware stock selection combined with patience is the most prudent way to approach the UK small‑cap opportunity set today.

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Source: Noah Wire Services