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The 'small cap effect'

Jason Rolf of Amati Global Investors looks at the propensity of smaller company shares to outperform larger ones.

Amati Global Investors


As we look back on 2017 as another strong year for UK small-cap equities our thoughts turn to the outlook for 2018 and beyond. A positive economy and negative real interest rates here in the UK have helped most asset classes climb ever higher but how much of this affects the small-cap equity market and can it continue?

First of all it’s worth defining small-cap. One of the most used benchmarks is the Numis Smaller Companies Index which is the bottom 10th, by value, of the main UK stock market. This index has been calculated back to 1955 so 63 years of history. In addition to the main stock market, there is the London Stock Exchange’s junior market called AIM (Alternative Investment Market) which has slightly easier rules for small companies wishing to list their shares and raise money in London, one of the most liquid capital markets in the world.

AIM celebrates its 23rd birthday this year and is a smorgasbord of listed firms ranging from the very small, valued at less than £1m, right up to the likes of ASOS and FeverTree valued at £5.5bn and £3.3bn respectively. The AIM market taken as a whole has not performed well – in the summer of 2016 it was still at the same level as it was when it started back in 1995. However the devil is in the detail and looking at the index as a whole overlooks some very high quality and established businesses, often with multi-generational stewardship where the grandchild of a founder might be holding the reins with large family holdings at stake.

So why the current excitement around AIM and why has it “come of age” after so many years in the doldrums? There are a number of factors at play:

  1. The rules on Inheritance Tax (IHT) which allow certain companies listed on AIM to qualify for Business Relief (previously Business Property Relief) after 2 years when the shares are held by an individual. Any qualifying shares held on death are removed from the estate to be taxed by HMRC and hence a potential saving of 40%. Such a simple and relatively quick mitigation of inheritance tax relief has brought large sums into AIM and caused the prices of some of the largest and most liquid companies to be over elevated against perceived fair value. This “IHT Effect” is no doubt keeping companies from seeking a full listing as they enjoy the enhanced ratings as a result.
  2. Since August 2013 AIM stocks have been allowed into ISAs which has increased their popularity, injected liquidity and probably added to the IHT-effect outlined above.
  3. Zero Stamp Duty on AIM stocks for private individuals since April 2014 has also helped, in combination with ISAs, in making them more attractive to investors.

The Small-Cap asset class itself stands up to greater scrutiny and a lot of research has been carried out over the years to try and break down the separate components or “factors” which drive share prices over time. These are Value, Size, Volatility, Yield and Momentum – Size (as in market capitalisation) is where decades of academic research has determined that smaller companies tend to outperform larger companies over time. In other words there is a premium to be gained by investing in smaller stocks although often this comes with lower liquidity and higher volatility. Some of the best research into this has been carried out by London Business School academics Dimson, Evans and Marsh who created the Numis Smaller Companies Index. They have calculated a 3.4% excess annualised total return over the All-Share Index going back to 1955, but only at an annual increase of 2.6% in the risk (as measured by standard deviation).

There are a number of reasons why this “small-cap” effect exists, and mainly these focus on illiquidity and lack of research on the individual companies, in effect creating a very inefficient market pricing mechanism and allowing for plenty of scope for active fund management. Generally, small-caps have a greater opportunity set  ahead of them, due to their  ability to react to new markets and changing environments, crucial in today’s fast changing world.


  • Eugene Fama, one of 2013's Nobel Prize economics winners, and his colleague Ken French, both of the University of Chicago, analyzed the "small-cap" effect in their famous 1992 paper, "The Cross-Section of Expected Stock Returns," covering the period between 1963-1990.
  • Dimson, Marsh & Evans, Numis, January 2018 (London Business School)

This article represents the views of the named author only. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.


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