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The Performance of Small Cap Mutual Funds: Evidence for the UK

This paper investigates the performance of mutual funds that specialize in investing in UK smaller companies. In contrast to mutual funds investing in large company stock, research on the small cap fund segment of the market is scant and suffers from methodological shortcomings. In this paper we address these issues by applying conditional multi-factor models tailored to smaller companies during 1992-2011. Our main results are fourfold. First, UK small caps funds deliver a statistically significant unconditional multi-factor alpha of 4.08% per annum, net of fees. This clearly deviates from previous work on large cap mutual funds which deliver significant underperformance in most developed markets. Second, we document a severe survivorship bias of 3.9% per annum. This raises doubt on previous small cap studies that did not include dead funds. Third, introducing time variation in betas consumes most of the statistical significance of alphas which indicates that small cap managers are successfully timing the market. Fourth, in contrast to the large cap literature, strong persistence (hot hands) exists for past winners. The top performing funds deliver a statistically significant alpha of 4.99% per year even after taking into account time variation in betas. We believe these results are relevant for both academics and practitioners when constructing efficient portfolios. In line with Otten & Bams (2002) we believe that the smaller market importance of small cap mutual funds compared to their small cap universe (< 5%) positively attributes to the observed outperformance of small cap mutual funds.