UK small caps have spent nearly a decade in the investment wilderness, hit by a succession of domestic and global shocks, persistent outflows and a shrinking universe of available funds.
But a combination of ultra-low valuations, rising corporate activity and early signs of renewed demand from institutions is prompting fresh debate among multi-asset managers about whether the sector is entering a new cycle.
Judith MacKenzie, partner and head of Downing Fund Managers, says the opportunity set is the strongest she has seen in more than 30 years. She argues that the number of profitable, well-run UK small-cap firms with solid earnings visibility, combined with what she describes as “artificially low” valuations, has created a rare entry point for investors.
“We are seeing a growing interest in UK smaller companies looking to IPO and a noticeable increase in pension funds wanting to invest in the sector,” she says.
“These dynamics are creating the conditions for strong growth in UK small caps.”
Morningstar’s latest UK Small-Cap Report reaches a similar conclusion. Its analysts estimate that UK small caps are trading at a significant discount to fair value, well below long-term averages and among the most undervalued parts of the UK equity market. Valuations also compare favourably on a global basis, particularly against US large-cap growth stocks.
A decade of headwinds
Sentiment towards UK small caps has been weak for years. Morningstar describes the past decade as a “series of unfortunate events”: Brexit uncertainty, Covid-19 disruptions, the 2022 mini-budget’s impact on interest rates, and the inflation shock following Russia’s invasion of Ukraine.
These pressures triggered 14 consecutive quarters of outflows from the sector, with assets now at 10-year lows.
Fund viability has also suffered, with Baillie Gifford, Aviva and Ninety-One among the managers to shutter UK small-cap funds. The category now has the fewest open-ended UK small-cap funds since 1997.
Henry Ince, analyst for equity strategies at Morningstar, says these long-running headwinds should not mask the fundamental strengths of the asset class.
“UK small caps have been out of favour in recent years, impacted by domestic and global issues like Brexit, Covid-19, and political instability,” he says.
“Assets are at a 10-year low after surging post-Covid, with more fund closures than launches so far in 2025. Despite these headwinds, the sector should not be overlooked. UK small caps remain attractively valued on both an absolute and relative basis, which has resulted in elevated share buyback and M&A activity.”
Buyers are returning
Corporate and private equity buyers have been quick to exploit depressed valuations. M&A activity has been rising steadily since 2020, particularly in high-growth subsectors. With private equity firms still sitting on substantial dry powder, Ince says the sector remains a “fertile hunting ground”.
Companies themselves are also taking action. Buybacks reached record levels in 2024 and have continued at pace this year, with both large and small UK corporates repurchasing shares. This is typically seen as a signal of board confidence and balance-sheet strength.
Meanwhile, the IPO pipeline is beginning to reopen. MacKenzie says Downing is seeing more UK smaller companies preparing to list than at any point since before the pandemic, suggesting improving business confidence and greater receptiveness from investors.
Policy support on the horizon
The Mansion House reforms may prove a meaningful tailwind. Under the Accord, major UK pension schemes have committed to allocate £25bn to UK assets by 2030, including FTSE AIM-listed shares.
Morningstar says the move represents a “much-needed sentiment boost” for UK smaller companies and could help reverse years of underweight positions among institutional allocators.
Monetary policy may also help. Historically, small caps outperform large caps after periods of rate cuts. With the Bank of England easing policy this year, some multi-asset managers see the potential for a cyclical recovery.
An opportunity for active allocation
For multi-asset managers, the question is whether these signals justify increasing exposure in portfolios that have become progressively underweight UK equity risk since 2016.
Morningstar highlights that UK small caps are one of the few UK equity categories where active management has consistently added value. Over the past five years, the active-manager success ratio in the EAA UK small-cap equity category is 59.1%, compared with around 25% for UK large-cap and mid-cap strategies. The only widely available passive option — the iShares MSCI UK Small Cap ETF — has struggled to match the dispersion of returns available to stockpickers.
“The broad and often overlooked universe creates an opportunity for active managers to add significant alpha over the long term,” says Ince.
Is the cycle turning?
After years of underperformance and investor scepticism, UK small caps now sit at the intersection of value, policy support, and improving corporate sentiment. For multi-asset managers considering their next allocation moves, the sector presents a challenge: does the combination of depressed valuations and structural tailwinds outweigh the lingering risks?
MacKenzie believes the answer is yes.
“This is the most exciting small-cap opportunity I have seen in my career,” she says.
“Well-run UK companies with strong growth prospects are trading at prices that make little sense. For long-term investors, this is an exceptional moment.”