Skip to content
Small clothes section sign on steel hanging rack with hangers in a department store

It’s common knowledge that choosing a stock picker who can beat the market over the long term is very difficult. But some investors still try, in the pursuit of those managers with the skill to identify stocks that will outperform. Yet even for those stock pickers who do deliver, our analysis suggests much of their performance is less due to skill than to investing in small companies.

Small clothes section sign on steel hanging rack with hangers in a department store

Investors still turn a blind eye to stock pickers’ failings

As we’ve written before, the evidence against stock picking is very strong, despite attempts by some in the investment industry to convince investors otherwise through marketing tools such as “best buy” lists. Put simply, the majority of active managers don’t deliver the outperformance after fees that they promise.

In fact, the most recent report card published by financial data provider S&P Dow Jones showed that for the year ending 2018, after fees, 80% of UK equity managers had not beaten their benchmark over three years, 69% did not beat it over five years, and a staggering 73.5% failed to outperform over 10 years.

Where performance comes from is just as important

Investors often concern themselves with a stock picker’s absolute performance track record – that is, whether they have outperformed the market by delivering “alpha” (a term used in financial markets to describe the excess return of a portfolio relative to the return of a benchmark).

Unfortunately, too little attention is paid to how this “alpha” is generated, and there are few tools available to retail investors to analyse this properly.

True alpha comes from individually selecting stocks that outperform others, but there is evidence that much successful stock picking actually consists of selecting groups of stocks that have similar characteristics. These characteristics are known in the investment industry as “factors”, academically researched attributes that can result in long-term outperformance. Examples of factors include:

Size. Small companies are typically viewed as riskier investments than large companies, meaning investors generally expect a higher return to compensate them for that risk. Small companies also have the potential to grow faster than big ones.

Quality. These are profitable companies with stable earnings and little debt. These kinds of firms are usually expected to outperform less profitable businesses with big debts and volatile earnings.

Momentum. If a company’s share price is rising, the stock is said to have momentum. Investors often predict that the movement will be sustained as other investors notice the trend and join in.

It should be mentioned that factors are no guarantee or guide to which individual stocks will outperform in the short term. However, they are characteristics of stocks that over the long term are observed to offer higher returns.

Are UK stock pickers relying on the “size” factor?

In order to understand whether UK stock pickers are relying on small companies over skill to generate some of their performance, we looked at the performance of funds in the UK All Companies sector compiled by the Investment Association, a trade group for the investment funds industry in the UK. The UK All Companies sector includes funds which invest at least 80% of their assets in UK equities which have a primary objective of achieving capital growth. We think this sector is a good measure of the performance of stock pickers who mainly focus on UK equities.

We wanted to see whether the success of stock pickers in beating the market mirrored the outperformance of small companies against large. Broadly, it did.

Over the past ten years, we looked at the number of financial quarters and calendar years in which funds in the sector outperformed the wider UK market, as measured by the FTSE All Share index.

Separately, we compared the performance of large UK companies, as represented by the FTSE 100 index, with that of smaller UK companies, as represented by the FTSE 250 index.

We found that since June 2009, funds in the UK All Companies sector tended to outperform the broad market in the same periods in which small companies outperformed large companies. Funds in the sector tended to underperform the broad market when smaller companies underperformed their larger peers.

This mirror effect was observed in 34 out of 40 quarters since June 2009, or 85% of the time. These quarters are shown in the chart below in light/dark blue whereas the quarters in which the mirror effect was not observed are shown in red and yellow.

Source: Morningstar, July 2019

A similar pattern was observed when we studied annual returns from 2009 to 2018. Here the co-movement was observed in nine out of 10 calendar years.

Beware what lies beneath

Our findings suggest a strong link between the success of UK stock pickers and the performance of UK small companies, which suggests that stock pickers are consistently tilting their portfolios towards higher risk and, typically, higher rewarding smaller companies.

This means investors in UK All Companies funds can expect their performance to be heavily influenced by the fate of smaller company stocks. This is an important consideration, especially given the current macroeconomic climate and ongoing Brexit negotiations. Smaller companies in the UK, such as those in the FTSE 250 index, tend to be more exposed to the domestic economy than large companies that often have a more global reach, such as the firms in the FTSE 100 index. A portfolio that was tilted towards small UK companies might be more vulnerable to the effects of a disorderly Brexit than one that invested in large firms.

There are other differences between small and large firms. For example, shares in smaller companies are often less liquid, meaning they are more difficult and expensive to buy and sell. The lack of liquidity in some small companies was highlighted by the recent suspension of Woodford Equity Income Fund, which invests in many small firms. Here, many investors were surprised at how many smaller companies were included in a portfolio they believed to be focused on the whole of the UK stock market.

At Nutmeg, we don’t use stock pickers in our portfolios. We focus on asset allocation and implement our investment views using exchange-traded funds (ETFs) that track indices, such as the FTSE 100. One of the primary reasons we favour ETFs in our portfolios is because they are transparent, meaning we know exactly what companies we hold and how performance is generated at any given time. ETFs do what they say on the tin – they provide low cost, transparent and reliable access to investment markets across stocks, bonds and commodities.


  1. Figures for UK equity funds compared with the S&P United Kingdom BMI contained in the full PDF report of the SPIVA Europe Scorecard (data as at 31 December 2018), which can be downloaded here:
  4. Morningstar, annual returns in GBP 2009 – 2018.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.