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ANALYSIS: Small cap funds – the golden boys of European equities

European equity mid and small cap funds have outperformed their large cap counterparts by a factor of five over the past two years. Why has this been the case, and will the outperformance endure?

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PA Europe

“When running a small cap fund, you don’t need to worry about a single stock. If you don’t own the largest constituent and its value doubles, that doesn’t really make a difference in relative performance terms. That can be quite different for large cap managers,” he says.

Growth has its limits

The good recent performance and the absence of competition by index trackers has led to relatively high inflows. Over the past two years, a net €3.9bn has been invested in the asset class. This is a substantial sum of money, considering the combined assets of all mid and small cap funds amount to only some €17bn, according to Morningstar data. This has led to the biggest funds in the universe such as the Threadneedle European Smaller Companies Fund and the Baring Europe Select Fund, soft-closing. The maximum amount of money a European small cap fund can absorb is generally thought to be about €2bn, and both funds are close to reaching this limit.

And interest is set to continue as the European economy is on its strongest growth trend since 2010. All four Eurozone purchasing manager indices (PMI’s) reached close to six-year highs in February. “There are good grounds of thinking that small caps should outperform large caps if PMI’s are rising, though PMI’s are not always right of course,” says Barings’s Williams. “But small caps are more exposed to domestic sales than large caps, and there is an earnings per share recovery available because of the domestic recovery in Europe.”

Alvaro Martin Sauto, head of multi-manager funds at Bankia in Madrid, is one of these investors eager to increase their allocation to European small and mid-caps funds. “We us these funds as a diversification strategy, and may increase our exposure in the coming future,” he says. “We are also planning to increase our positions in Spanish small and mid-caps but we haven’t chosen the fund yet.”