If you think back to when ISAs were first launched in 1999, it wasn’t exactly an auspicious time to start investing.

The tech bubble was about to burst, the split cap investment trust scandal was about to explode, and stocks were about to fall into a three-year bear market. But despite that, the first ISA savers have been rewarded by putting their best foot forward, and investing money in the market.

Over the last 22 years, the average fund sector has turned £1,000 invested into £4,257 today. Not bad at all, particularly considering the market turmoil at the start of the millennium, but returns have been even more impressive from smaller companies funds.

Of the 10 best performing funds since April 1999, seven focus on investment in smaller companies, including Marlborough Special Situations (B907GH2) which tops the list.

Smaller Companies funds investing in the UK feature most prominently in the list of top performers, which is probably a reflection of a higher number of funds operating in this area on behalf of UK investors. But if we cast the net a bit wider, we can actually see that superior long term performance from smaller companies is apparent across all developed markets.

SMALLER WITH MORE SCOPE TO GROW

The table below shows performance of the main fund sectors investing in the UK, Europe, North America and Japan, where funds invest predominantly in larger blue chips, with some medium sized companies to boot.

Included for comparison is the performance of smaller companies fund sectors investing in the same regions. Across all four markets, returns from smaller companies funds have trounced those from more mainstream funds.

Smaller companies funds tend to be more volatile than blue chip investments, but they have the potential for significant outperformance over the long term for two reasons. The first is this part of the market itself is likely to deliver better returns, because the companies in the index have greater capacity to grow; they are often small fish in a big tank.

ACTIVE MANAGEMENT VINDICATED

The second reason is that active managers can make an extremely telling difference in the smaller companies market, because it is less heavily analysed, so fundamental research can reap significant rewards.

Small cap fund examples

TB Amati UK Smaller Companies (B2NG4R3)

Paul Jourdan has been running this fund for more than 20 years and the whole team is steeped in experience when it comes to small cap investing. They look for high quality companies with competitive advantages. They have an emphasis on the AIM market, but they can invest in stocks all the way up to the FTSE 250.

Standard Life UK Smaller Companies Trust (SLS)

Fund manager Harry Nimmo has been running this trust since 1993. He wants to invest in tomorrow’s largest companies today, and so runs a concentrated portfolio of smaller companies with good growth prospects and robust finances, so they can weather the occasional storm.

Tellworth UK Smaller Companies (BDTM8B4)

Paul Marriage and John Warren don’t invest in oil & gas, mining, or biotech, preferring instead to focus on more predictable areas of the market. They look for market leaders that have pricing power, as well as misunderstood companies that are going through a period of change.

The average UK Smaller Companies fund has returned 756.6% since 1999, compared with 403.8% from the underlying market, as measured by the FTSE Small Cap Index. That’s quite some outperformance, and a serious vindication of active management in this area.

Investors thinking about where to put this year’s ISA allowance for long-term growth shouldn’t therefore overlook smaller companies funds. As the numbers show, small can be beautiful (even if past performance isn’t always a guide to future performance).

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