Small really is beautiful

One of the best-documented relationships in investing is the link between size and return. Put simply, smaller companies tend to produce bigger returns over time. Fund manager Gervais Williams notes that £1 invested in UK stocks in 1955 would have grown to £1,000 (with dividends reinvested) nearly 50 years later. Not bad. But you'd have made five times that much had you bought the smallest 10% of stocks.

Yet if this outperformance is widely recognised, why isn't it exploited more? It's partly about size. If you are a fund manager sitting on billions of pounds, then you simply can't invest enough in the smallest stocks (microcaps) for their performance to make much difference to your portfolio. But there are other drawbacks to small caps,which some argue account for the higher returns on offer (you get nothing for free when investing, so there has to be a catch).

Firstly, costs are higher. The gap (or spread) between the bid price (what you can sell a stock for) and the ask price (what you'll pay) tends to be higher, the smaller the share. For example, Aswath Damodaran of New York University looked at total transaction costs for NYSE stocks, and found they ranged from 0.31% for the largest to 3.8% for the smallest.

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Another issue is the relative lack of information available. Far fewer analysts cover small caps than bigger companies. This is an opportunity for diligent investors to find undiscovered bargains, of course. But it also makes it easier for dodgy or high-risk firms to slip through the net, as the countless tales of high-profile rags-to-riches-and-back-again stocks on London's Alternative Investment Market demonstrate.

So is it worth putting smaller companies in your portfolio? Yes but with a few caveats. Firstly, avoid overtrading you should do this anyway, but the costs matter even more when dealing with small caps. Secondly, take a long-term view history shows that small stocks have done well over time (although there's no guarantee that will continue). That doesn't mean they'll do well over the next week, month or year. So if you do buy in, have patience and if you don't fancy doing all that research yourself, there are several funds that will do the legwork for you. We look at some of the most interesting in the box below.

Four funds to help you avoid the legwork

iShares MSCI UK Small Cap UCITS ETF (LSE: CUKS)

total expense ratio (TER)

However, you might be surprised to realise that the average market cap of the companies in its portfolio is just over £1bn and includes companies such as housebuilder Bellway, utility group Pennon and pest controller Rentokil none of which, we suspect, most readers would perceive as tiny or even particularly small companies. You'll also find that many "smaller companies" funds and investment trusts might perhaps be more accurately described as "anything but FTSE 100 stocks".

For what most of us might think of as genuine small companies, you'd ideally want to track something like the Numis Smaller Companies Index (which holds the smallest 10% of listed UK companies). Sadly, you can't there are no trackers available.

However, there are several actively managed funds that focus on these sorts of companies. The Miton UK MicroCap Trust (LSE: MINI) hasn't been around long enough to have a track record to speak of, but it's run by the highly respected Gervais Williams (see our interview with him on the website) and Martin Turner. It invests in companies with a market cap less than £150m, and has a TER of 1.88%. It currently trades on a premium to net asset value (NAV) of around 6.8% (it has traded at a premium since launch).

Another option is the River & Mercantile UK Micro Cap (LSE: RMMC). It aims to invest in companies with a market cap of under £100m. It charges 1.75% plus a 15% performance fee, and trades at around its NAV. Another option is Strategic Equity Capital (LSE: SEC). The trust invests in larger stocks than the other two the average market cap is around £300m but it has a highly concentrated portfolio of 20 holdings, and can invest in unquoted firms. According to the Association of Investment Companies, the share price is up by 140% over five years, the ongoing charge is 1.44%, and it's on a discount of around 4%.