It’s been a tremendous month for the UK stock market, with the UK index forging ahead of international peers, including the mighty S&P 500. This is an encouraging performance for long suffering investors in the UK’s flagging benchmark index, but we shouldn’t get too carried away with ourselves. The rise in the Footsie has been part of a global risk rally over the last month, and while it’s pleasing to see the UK near the top of the leaderboard for a change, a rising tide has been lifting all boats.
Indeed, looking at performance in the year to date the UK stock market has still fallen short of indices in the US, Europe and Japan. One swallow doesn’t make a summer, and the UK still has significant ground to make up on international peers to regain some ballast in the global stock market. The country’s weighting in the MSCI World Index is all-important because it holds the key to global capital flows. Some sustained outperformance could create a virtuous circle for the UK stock market as more new money flowing into global funds heads towards the UK.
But a solitary month of rising share prices isn’t going to cut the mustard, particularly when other international indices aren’t too far behind. The UK weighting in the MSCI World Index currently stands at 4%, down from around 10% just over a decade ago. Probably the biggest swing factor that could improve the UK’s lot is a pullback in the US stock market. There’s no sign of that as the S&P 500 continues to crunch upwards, and in any case, a bad spell for the US market could well have knock-on negative effects for sentiment on this side of the pond.
Source: FE total return in local currency to 15 May 2024
Three UK indices trading well below their peak
While the FTSE 100 has been making headlines by hitting fresh highs, three other UK stock indices representing more modestly sized companies are still trading below their peak levels.
The FTSE 250 is currently trading 14% below its September 2021 peak. Likewise the FTSE Small Cap ex Investment Trusts index. Meanwhile the FTSE AIM is still 73% below its record high reached in March 2000, which tells us something about the volatility of this market. Discounting the dizzy euphoria of the millennial market, the FTSE AIM All Share index is currently trading 40% below its September 2021 peak. All these indices have participated in this years’ stock rally, but haven’t hit quite the high notes of the FTSE 100. The outperformance of the FTSE 100 isn’t a good sign for active managers, who tend to be overweight mid and small caps in their portfolios.
Sources: Refinitiv and Morningstar. *Closing prices. **Closing price 15 May 2024
Why invest in smaller companies?
Medium and smaller companies can be more volatile and less liquid than the big beasts of the FTSE 100. But they also come with the potential for more upside. Their smaller stature gives them greater scope to grow, and they are also less well scrutinised, which means it’s possible to unearth hidden gems. Indeed, this is one reason active managers like to go fishing in these markets. The FTSE 250 in particular has been a standout performer over the very long term, returning 498% over the last 20 years compared to 300% from the FTSE 100. That’s not a bad tail wind to have blowing in your favour if you can take a long-term view.
And while the FTSE Small Cap ex IT index has failed to beat the FTSE 100 over 20 years, the average fund investing in smaller companies has done so comfortably, returning 430%. Partly that’s because these funds will invest further up the cap scale in the FTSE 250 as well as the small cap index, and look for opportunities in the AIM segment too. But it also reflects the fact that if you can sort the wheat from the chaff in this market, you could harvest some very healthy rewards.
AIM stocks also come with a potential IHT benefit. Qualifying stocks do not form part of your estate providing you hold them for at least two years before death. Large amounts of money are invested in this market for this very reason, which does present a risk for investors if tax rules change. The fear used to be that the IHT relief afforded to AIM companies might be axed, but more recent rumours the government is considering abolishing Inheritance Tax altogether is unsettling for AIM investors. This would put AIM companies on a par with other stocks and would likely result in significant flows out of the market. The tight fiscal situation and likelihood of a Labour election win makes this a tail risk, but one worth acknowledging.
How to gain exposure to mid and small caps
Investors can of course pick their own stocks for inclusion in a portfolio, though it’s especially important to maintain diversification when investing in smaller companies because of the heightened risks involved. Those investing in AIM who wish to take advantage of the IHT benefits can only do so through individual stocks or professionally managed portfolios of individual stocks; funds investing in AIM will not qualify.
Most active managers investing in the broad UK stock market will have an overweight position in small and mid-caps, but there are also funds which target these areas specifically.
WS Amati UK Smaller Companies: Dr Paul Jourdan has been running this fund for over twenty years and the whole team is steeped in experience when it comes to small cap investing. They look for high quality companies with competitive advantages. They have an emphasis on the AIM market, but they can invest in stocks all the way up to the FTSE 250.
Tellworth UK Smaller Companies: Paul Marriage and John Warren don’t invest in oil and gas, mining, or biotech, preferring instead to focus on more predictable areas of the market. They look for market leaders that have pricing power, as well as misunderstood companies that are going through a period of change.
Montanaro UK Income: an income fund with a difference, Montanaro UK Income looks for dividend paying opportunities amongst the UK’s small and medium-sized companies, which adds to its risk, but also provides greater growth potential in capital and dividends.
Vanguard FTSE 250 ETF: simple, passive exposure to the UK’s midcap segment with a fund charge of just 0.1% per annum.
These articles are for information purposes only and are not a personal recommendation or advice.