We don’t support this browser anymore.
This means our website may not look and work as you would expect. Read more about browsers and how to update them here.

Skip to main content
  • Register
  • Help
  • Contact us

The ‘size effect’ – the case for investing in smaller companies

We look at what ‘small’ really means, why you could consider them and share two investment ideas.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

It's not the size of the dog in the fight, it's the size of the fight in the dog. This old adage shares parallels when it comes to investing.

Smaller companies can certainly punch above their weight and despite their performance potential, they can often be overlooked in a portfolio.

In this article, we look at what ‘small’ really means, why you could consider them and share two investment ideas.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments will fall and rise in value, so you could get back less than you invest.

How do you define ‘small’?

Depending where you look or who you ask, the definition of ‘small’ can vary.

The size of a company can depend on the environment they operate in. For example, a company considered small in one region could be relatively large compared to another.

A company’s market capitalisation – the total number of its shares in issue multiplied by the latest share price – is a common sorting method and way to size a company. Companies with lower market capitalisations are considered to be smaller, hence the name ‘small cap’. Remember though, just because these companies are ‘small’ today doesn’t necessarily mean they will be tomorrow as they could grow over time.

To put this into perspective, the chart below highlights the ceiling for the definition of a smaller company across several global regions. The US is home to some of the biggest in the world with the maximum being 13 times larger than Egypt. In Europe it’s a similar story, particularly for countries like the UK, Italy and Germany. Naturally those based in less developed emerging markets tend to be further down the market capitalisation spectrum.

Maximum market cap of a smaller company by country

Source: abrdn, 31/12/2021.

Understanding risk - why company size matters

Punching above their weight

Academic research has long suggested that smaller companies have tended to outperform larger ones. This is sometimes referred to as the ‘size effect’ and ‘size premium’.

The chart below highlights the additional 193.9%* returned by smaller companies compared to their large cap counterparts since the start of 2003 when the FTSE index launched. Although, the journey has been bumpier. Remember though, just because they’ve done well in the past doesn’t mean this will continue.

Global large cap vs small cap performance

Past performance isn’t a guide to future returns. Source: *Lipper IM, to 31/01/2022.

Annual percentage growth

Jan 17 – Jan 18 Jan 18 – Jan 19 Jan 19 – Jan 20 Jan 20 – Jan 21 Jan 21 – Jan 22
FTSE Global Large Cap 13.82% 0.65% 17.11% 13.28% 16.47%
FTSE Global Small Cap 9.59% -0.61% 11.08% 17.58% 8.03%

Past performance isn’t a guide to future returns. Source: Lipper IM, to 31/01/2022.

But what makes them so attractive?

Imagine a shipping tanker, changing course takes time and planning ahead is paramount. In contrast, a smaller vessel, like a speed boat, can easily navigate and if needed avert at the last moment. The speed boat is the smaller company – it’s nimble.

They also tend to be less bureaucratic which means there are fewer layers of management. The benefit of this is increased agility and the flexibility to adapt to changing market conditions. This can give them the edge over larger companies – the shipping tankers.

The drivers of returns are also different from larger companies, which can help offer diversification. While some smaller companies make money overseas, it’s likely their home market is their primary focus. On the other hand, larger companies often do business overseas as well. While this brings potentially more opportunity, it also means they have to deal with other potential challenges, like currency fluctuations or tariffs.

They only make up a slither of the global stock market, so smaller companies are also often overlooked by analysts. For example, one study suggests only three analysts cover a UK small/medium-sized company compared with 22 for a larger one. An under researched part of the market can be a stock pickers paradise and can offer lots of opportunity to uncover hidden gems.

Smaller companies are riskier than larger ones. They tend to trade less frequently than bigger shares so can sometimes be harder to sell.

Investing in Smaller Companies

Small caps are at the forefront of innovation and let investors get access to some of the most exciting trends and emerging themes. They keep larger companies on their toes with the threat of market disruption. And in some cases, smaller companies are creating entirely new markets altogether.

It’s important that investors do lots of research, which requires both time and information. Time you might have, but information isn’t always easy to come by, especially when it comes to smaller companies.

It could be worth leaving it to an expert, like a professional fund manager, to make the underlying investment decisions of what the fund invests in.

We think active managers (ones that try beat the market) can really add value in this part of the market, although this isn’t guaranteed, and some managers do underperform. We have several on the Wealth Shortlist, a list of funds selected by our analysts for their long-term performance potential. We take a closer look at two of those fund below.

Smaller companies should only be considered as a small part of a portfolio. It could form part of a more adventurous portfolio for the long term. We think it’s a good idea to use them alongside other investments in larger companies. Blending them with different geographies and types of investments can help diversify a portfolio.

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

ASI Global Smaller Companies

We think ASI Global Smaller Companies could be a good option to add diversification to a portfolio, while investing in smaller companies around the world. Kirsty Desson and her team champion the benefits of investing in companies considered too small by many other global fund managers. They look in both developed and higher-risk emerging markets to find businesses they think are high-quality, growing and have momentum behind them.

This process results in a portfolio of between 40 to 80 companies. Around half the portfolio is invested in the US, although this is less than the global stock market.

In contrast, they invest more than the benchmark in European countries like the UK, Italy and Germany. The manager can also use derivatives, which can add risk if used.

MORE ON ASI GLOBAL SMALLER COMPANIES, INCLUDING CHARGES

ASI GLOBAL SMALLER COMPANIES KEY INVESTOR INFORMATION

Artemis US Smaller Companies

Outside the usual names that dominate the US stock market, we think Artemis US Smaller companies could be a good addition to the US portion of a portfolio. Cormac Weldon has managed the fund since launch in October 2014. He has plenty of experience investing in the US market, having invested there since 2001, and is a manager we rate highly.

Weldon has more than 2,000 potential companies to choose from, but he only invests in around 40-60. While this can increase performance potential, holding a smaller number of investments can increase risk.

He only invests in those where he believes the upside potential is double the downside risk. This is achieved through number crunching their profitability and growth prospects over time.

The team also meet with company management on a regular basis which helps build their understanding of the business model and assess the quality of the management team.

MORE ON ARTEMIS US SMALLER COMPANIES, INCLUDING CHARGES

ARTEMIS US SMALLER COMPANIES KEY INVESTOR INFORMATION

Fund insight: our weekly email

Sign up to receive our expert fund research and insights.

Please correct the following errors before you continue:

    Existing client? Please log in to your account to automatically fill in the details below.

    Loading

    Your postcode ends:

    Not your postcode? Enter your full address.

    Loading

    Hargreaves Lansdown PLC group companies will usually send you further information by post and/or email about our products and services. If you would prefer not to receive this, please do let us know. We will not sell or trade your personal data.

    Our fund research is for investors who understand the risks of investing and that investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

    What did you think of this article?

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

    Editor's choice – our weekly email

    Sign up to receive the week's top investment stories from Hargreaves Lansdown. Including:

    • Latest comment on economies and markets
    • Expert investment research
    • Financial planning tips
    Sign up

    Related articles

    Category: Funds

    Asia & emerging markets review – an unpredictable year so far

    We reflect on an eventful year so far for Asian and emerging markets, how economies and stock markets have been holding up, and what investing styles have held up best.

    Kate Marshall

    23 May 2022 8 min read

    Category: Funds

    Index funds vs ETFs – what investors need to know?

    We look at some of the key differences between index funds and exchange traded funds (ETFs).

    Alex Watkins

    23 May 2022 4 min read

    Category: Funds

    Vanguard S&P 500 ETF: May 2022 update

    In this update, Passive Investment Analyst Alex Watkins shares our analysis on the manager, process, culture, ESG Integration, cost and performance of the Vanguard S&P 500 Exchange Traded Fund (ETF).

    Alexander Watkins

    20 May 2022 7 min read

    Category: Funds

    iShares Core FTSE 100 ETF: May 2022 update

    In this update, Passive Investment Analyst Alex Watkins shares our analysis on the manager, process, culture, ESG Integration, cost and performance of the iShares Core FTSE 100 Exchange Traded Fund (ETF).

    Alexander Watkins

    19 May 2022 7 min read