While small caps tend to do better than large caps over the longer term because of the risk and illiquidity premium connected to smaller companies, the outperformance of European small caps over the last two years or so has been exceptional.
Over the same time period, the FTSE 250 has hardly outperformed the FTSE 100, and US large caps have actually done better than small caps.
Political risk
European mid- and small-cap companies have done so well because there are a lot of growth-oriented companies in the universe that are not priced as such, partly because of the (political) risk associated with Europe, says Oliver Collin, co-manager of the Invesco Continental European Small Cap Equity Fund.
A quarter of continental European small caps are industrials, while large caps are more focused in the financial, healthcare and consumer staples sectors.
"There are good grounds of thinking that small caps should outperform large caps if PMI’s are rising. Small caps are more exposed to domestic sales" - Nicholas Williams
A stock pickers market
While the small cap index has outperformed its large cap counterpart over the past three years, small cap funds have also done a better job compared to their index than most large cap funds.
According to Morningstar data, all of the largest four mid and small cap funds with a track record of at least three years have outperformed the Euromoney Continental Europe Smaller Companies Index over both 1- and 3-year periods.
Moreover, small cap funds overall have outperformed their index over the past three years, though this is partly because some of these funds don’t invest in UK small caps (which have underperformed the wider market because of sterling depreciation over the period).
This is because small caps are a better market for stock pickers. All small cap managers you meet will tell you one of the reasons they can find alpha for your more easily is that their market is ‘underresearched’, which is of course true.
The European small cap universe consists of some 5,000 companies, more than 10 times the number of stocks represented in the MSCI Europe. And the market is covered by a lot fewer analysts too: according to FE Analytics data, there are about five times more large cap than small cap funds in the European equity space.
Because there are so many stocks to choose from and no single stock has a benchmark weighting of more than 0.5%, small cap managers are naturally less focused on a benchmark than their large cap counterparts, explains Nicholas Williams, head of small cap equities at Barings.
