When it comes to investing, think small?

A couple of new forecasts have just come out suggesting that by the summer of 2014, the UK economy will overtake the peak level it reached before the 2008 crisis.

The British Chamber of Commerce (BCC) has upgraded its economic forecast and now believes that economic growth will be up 2.8% this year. A survey by accountancy firm BDO also believes that UK economic output will surpass pre-recession levels by the summer.

This is good news at the start of a month which represents the five year anniversary of the 0.5% base rate. It is also five years since the FTSE 100 hit a low of 3,512. Five years on, the FTSE 100 is running at c.90% above that figure and many are expecting it to go even higher.

These are all positive noises for potential investors. So for those planning to invest in the near future, which funds should you be looking at? You may think that you have identified an excellent fund manager. If so you should remember the ubiquitous compliance disclaimer – “past performance is no guide to the future - not because no one can maintain exceptional returns over the long term or because of a belief that a fund manager’s performance is down to luck. It is more due to the impact of the herd instinct. Good fund managers tend to attract more money to their funds - and their very success makes it harder for them to deliver the returns in the future.

A good example of this is Neil Woodford, erstwhile star fund manager of the Invesco Perpetual Higher Income fund for 25 years. Over the past 10 years the amount of money in the fund rocketed from £2.4bn to £13.6bn and this inevitably saw lower returns compared to his earlier annual returns averaging around 13%.

In simple terms, big funds have to buy big companies - and big companies cannot grow as quickly as small ones. In the early days, a good £10m investment idea would have a major impact on a fund’s returns, but not on a fund of £13.6bn. So over time, it becomes more difficult for large funds to differ markedly from the broader market – making them in some cases almost “closet trackers”.   

Even if the manager of a large fund identifies a significantly undervalued company, for it to make any difference to the fund’s performance, he or she must buy a very substantial stake. And this is easier said than done.

As an individual investor, you simply tell your broker how many shares you want at the price stated. For institutional buyers of tens of millions of shares, it’s a little bit different. Quite likely there are not enough sellers around, so building the desired investment stake could take days – or longer. In the meantime, other investors could realise that there is a big new buyer in the market and decide to sell only at a higher price. It is easier for smaller funds to buy enough shares to make a difference.

So whilst there is not a lot of point in a big fund buying shares in small companies, small funds can obviously buy big companies. This means small funds have greater flexibility when it comes to exploiting opportunities of all sizes, and this can potentially give them an edge.

Having said that, investors naturally to want to put their monies in the perceived safety of a successful fund. However, this could mean missing out on the best returns. On the other hand, opting for a small fund with a shorter track record of outperformance can be more risky. To some extent, this decision comes down to your attitude to risk.

With large funds, investors therefore need to weigh up the benefits of having a star fund manager against the degree to which the fund’s size restricts his or her freedom of action. The ideal solution could be to find an up and coming good manager who runs a smaller fund – and has done so for at least three years.

Another option is to use “fund of funds” managers, who allocate your money to baskets of funds, not shares. Our multi-manager investing approach could come into play here. Multi-manager investing provides you with a ‘one-stop’ investment solution, with a diversified portfolio managed by ‘best of breed’ investment managers.

These are just some of the many issues that you need to consider before investing. This is where expert financial advice can be useful.

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