Having exposure to smaller companies is meant to bring some excitement to a diversified portfolio. Unfortunately, some investors’ hearts might be racing due to pain rather than pleasure this year.

Historically this part of the market has outperformed larger companies. For example, between 1955 and 2019, the Numis Smaller Companies index (excluding investment trusts) beat the FTSE All-Share index by 3.3% a year on a total return basis.

While that is an impressive statistic, it is important to note smaller companies do not always outperform, as we have seen this year. The FTSE 100 index of large companies has generated a 3.8% total return whereas the Numis Smaller Companies index (including AIM shares but excluding investment trusts) has lost 9.7%.

Even more alarming is that 51 out of 74 funds and investment trusts focused on the UK smaller company space have underperformed the Numis index in the year to 12 April, according to data from FE Analytics. Investors pay a fund manager a fee to beat the market and such widespread underperformance is disappointing.

To the fund industry’s credit, looking at such a short time period is unfair. Fund managers should be judged on a longer-term basis.

Most of the UK smaller company shares which have done well this year are unlikely to feature in the typical UK small cap fund. The top performers list is dominated by tiny oil, gas and mining companies which are riding high because of a hike in commodity prices. These types of companies are fraught with risk as they are often heavily indebted, loss-making and have no control over the pricing of their product.

Many fund managers prefer to back companies which are in a strong financial position, have a differentiated product or service offering, and where there is a clear path to growth.

Smaller companies which delivered bad news in recent months have been punished hard by investors. Some of the worst share price performers have been companies which missed market expectations with trading or have come under financial pressure.

Difficulties finding enough staff, failing to achieve the anticipated level of business as Covid restrictions ease, and a general slowdown in growth are among the reasons behind share price declines.

History suggests a pattern of long-term outperformance punctuated by shorter periods of lagging performance for smaller companies. Private banking group Julius Baer says small caps have lagged in periods when economic activity has been weak.

Investors owning smaller companies need to accept that we’ll see more of the dips that have shaken portfolios this year. Julius Baer suggests someone might want to lean more to smaller companies when economic conditions are good and retreat to larger companies when storm clouds gather (such as we are seeing now).

There is logic in that view yet permanently maintaining some exposure to small caps seems like the most sensible way forward.

It’s no good selling out completely when valuations have already fallen. Instead, you may find it better to allocate new money in your portfolio to larger companies if you’re nervous about the current economic outlook.

Keeping an existing small cap portion in your portfolio will mean you’ll benefit when the market starts to favour these types of stocks again.

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