The best funds to buy to play a British recovery

Last time, I raised the almost heretical idea that investing in the British economy might be an interesting, if speculative punt just now. I'll not repeat the reasons here, but the bottom line is that for me, Britain looks a much more attractive destination for my money than many comparable economies. Probably the cleanest way to play a British recovery is via a FTSE 250 fund or tracker. But if the economy does rebound more strongly than we expect, then it's reasonable to expect British small-caps to carry on increasing in value too.

I say carry on' because they have already had an excellent few years. The broad MSCI UK Smaller Companies index (which includes a large chunk of smaller FTSE 250 firms) is up 38% over the last year.

As the most risky and volatile equity investments, we'd reasonably expect these stocks to shoot up if stock investors feel bullish. But there's also a more interesting long-term investment angle: the small-company effect'. Talk to academics such as Professors Elroy Dimson and Paul Marsh at the London Business School, and they'll suggest that small caps have trounced most other classes of shares over the very long run, for several reasons. There's the obvious fact that small firms can grow fast and eventually become large caps.

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Volatility also has an impact. The more volatile the share, the greater the opportunity to make money in the long run. Whatever the driver, investing in British small caps has been a smart move over the last half century, not to mention the last 12 months!

Valuations now look a bit hairy, but if the economy does canter ahead, there may be more room for share-price growth over the next 12 months. The key driver could be rising profits, as domestic British firms begin to repair balance sheets, increase profit margins and invest for the future.

What are the best funds to play this? In the British small-cap sector, active fund management wins hands down over passive (tracker) funds. There are a few small-cap exchange-traded funds (ETFs), including an MSCI UK Smaller Companies fund, which iShares inherited after it took over Credit Suisse: iShares MSCI UK Small Cap (LSE: CUKS). Over the last year, this has delivered a very decent 37% price return, better than the average actively managed unit trust.

The total expense ratio (TER) is also reasonable at 0.58% a year. But it's a relatively new fund and on balance the sector has simply too few trackers, with limited track records, to analyse. I also worry that the MSCI Smaller Companies index is too inclusive: it covers the bottom 14% of the market by market cap, which includes many mid caps.

On the active side, the choice is wider, with several great managers with long-term track records. The key choice is whether to use an investment trust or a unit trust. To me, the record speaks for itself: investment trusts in the sector have a better record than unit trusts, in terms of performance and underlying fees.

According to the Investment Management Association, the average unit trust in the UK Smaller Companies sector returned 32% over one-year, 62% over three, 80% over five and 202% over ten years. According to Numis, the equivalent for the average investment trust is 36% (one year), 71% (three), 95% (five) and 254% (ten). TERs are also consistently 0.5% to 1% lower for investment trusts.

We shouldn't read too much into these averages there are some excellent unit trusts that have blown those numbers out of the water. These include Old Mutual's UK Smaller Companies (and Focus) funds, run by Daniel Nickols; Fidelity's UK Smaller Companies fund run by Alex Wright; Cazenove UK Smaller Companies run by Paul Marriage; and Giles Hargreave's various Marlborough funds, including Marlborough Special Situations and Marlborough UK Micro Cap Growth.

But if you prefer an investment trust, there are three outstanding choices : BlackRock Smaller Companies (LSE: BRSC) managed by Mike Prentis; Henderson Smaller Companies (LSE: HSL), managed by Neil Hermon; and Harry Nimmo's Standard Life UK Smaller Companies (LSE: SLS).

Many of these managers run dual mandates: an investment trust and a unit trust. I'd always go for the investment trust versions. The Henderson investment trust has a base fee of 0.35% and a TER of 0.53%. The unit trust has a base annual management charge of 1.5% plus extra costs. That's a 1%-plus difference simply for the privilege of buying through a unit trust platform.

There are two other variations on the active small-cap fund theme to consider. Investors looking for income should look at the Acorn Income Fund (LSE: AIF), which has a great record of focusing on dividend-paying small caps, plus Gervais Williams' Miton Income Opportunities (LSE: MIOT) and the Diverse Income Trust (LSE: DIVI). Both funds have a superb record of growing not only the capital value of the shares, but also the income stream.

Then there's shareholder activism. Richard Bernstein's Crystal Amber fund (LSE: CRS) takes chunky stakes in small- to mid-cap companies, then agitates for change. The fund has just raised extra money to increase its firepower. Bar the odd disaster, Bernstein has a good record in pushing for extra returns to shareholders. I'd also put Marwyn Value (LSE: MVI) on your radar. This very focused, value-driven group take an incredibly active role in their target companies. It's one to watch.