Link between risk and return is clear as markets deal with the unexpected

OVER the last few years the salient feature of equity investing has been the outperformance of small and mid-cap stocks at the expense of large cap shares.

The simplest way to demonstrate that is to contrast the 25.3 per cent total return of the FTSE 100 over the last five years to May 31 with the 63.5 per cent return of the FTSE 250 over the same period.

During that same time the FTSE Small Cap index increased 59.2 per cent so it is not a straightforward case of saying the smaller the company the better the performance. Even so, it is clear that the big blue-chip companies that so dominate the stock market in terms of valuation, cash generation and news flow have lagged behind their smaller listed brethren.

Some of that has been a result of re-rating. Larger companies are often seen as dividend-paying cash-cows while the mid-caps might be viewed as nimbler and more agile competitors able to exploit niches in their markets.

As a consequence the valuation measures applied to larger companies have drifted lower while the mid-caps have edged upwards. Nevertheless, earnings have probably grown a little faster for the constituents of the 250.

It is important to remember though that the 250 companies in that sector account for only about 17 per cent of the market capitalisation of the FT 350.

Even before the sharp moves triggered by the surprising result of the EU referendum there were signs that change was in the air as the 250 lagged the 100 index over the first five months of the year.

In June that difference increased with a near six per cent fall in the 250 in contrast to a two per cent rise in the 100 so that in the first six months mid-cap shares have lagged the big caps by 11.8 per cent. That may not sound very dramatic but when markets are doing little, or declining, it makes a huge difference to returns.

Nowhere is that more obvious than in the discrepancies between the performance of active funds and passive funds where, among many differences, probably the largest is the overweighting to smaller companies in the majority of active funds.

Maybe active managers feel that this group is less well researched than those in the FTSE 100 or perhaps it is a function of active funds selecting less liquid stocks to benefit from a scarcity premium as their own activity moves the market.

Who knows? But this year the downside of smaller companies, their higher risk, is becoming more evident.

It is clear in recent years that the high-beta (i.e. higher volatility) of mid and smaller-sized stocks is a benefit in rising markets but a disadvantage when markets fall.

An example of the two most extreme years in the UK stock market over the last 10 years illustrates the point. In 2008 the FTSE 100 fell 28 per cent but the FTSE 250 dropped 38 per cent.

However, in the following year the mid cap index gained 51 per cent against a rise of “only” 27 per cent for the big cap index.

No one knows how this year will pan out but it is clear from the movements in June that the higher risk from mid-cap shares cannot be separated from returns.

In the long run, there should not be a discernible difference in the risk adjusted returns between large and mid-sized stocks. But when markets are volatile the higher risk in smaller stocks might help on the upside but it does hurt on the downside.

Both get to the same destination but the larger companies give a smoother ride. The seven years since QE started have encouraged risk-taking to the benefit of smaller firms at the expense of larger ones.

In a cautious world the attractions of larger, more liquid and less volatile firms are evident and it is reasonable to think that they will attract a premium now rather than a discount.

‘‘ When markets are volatile the higher risk in smaller stocks might help on upside but hurts on downside

Robert Davies is adviser to the VT Smart Dividend UK Fund.