Small caps: the best companies you’ve never heard of

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The spotlight is slowly being turned back onto UK small caps. This week marks the 30th anniversary of the Alternative Investment Market, known as AIM, a sub-section of the London Stock Exchange designed for young, fast-growing businesses.

The anniversary has amplified calls for greater investment in this area, with the chief executive of the London Stock Exchange saying we need to “rebuild risk culture” in the UK.

The government seems to be listening. It plans to funnel more pension savings into UK companies, including small ones, via the Mansion House Accord. This agreement was signed last month by 17 pension providers and aims to unlock up to £50 billion of investment.

But what do you need to know before investing in small caps?

1. Small caps have the power to outperform...

Research shows that small companies can outperform large ones over the long term. One of the most closely watched benchmarks is the Deutsche Numis Smaller Companies Index. This tracks the bottom 10% of the main UK market (excluding investment trusts) and has data stretching all the way back to 1955.² 

Academics Scott Evans and Paul Marsh review the index every year and have identified a clear ‘size premium’ - a positive difference in the annualised return delivered by small caps versus large caps.

“Our long-run analysis also shows that, despite setbacks in recent years, the small-cap size premium remains intact,” they concluded in January.

Since 1955, UK small caps have beaten not only the FTSE 100 but US equities, bonds and house prices by a significant margin.

This size premium is observable the around the world. Only one market - Taiwan - has bucked this trend over the past 25 years.

2. …but they are risky

Investing in individual small companies is very risky, and even small cap indices can be volatile. Shareholders all but gave up on this segment of the market during the 1990s after a decade of poor performance, before the size premium started to reassert itself.

Predicting what will happen year to year is also very difficult. In 2024, large caps outperformed the smaller companies index, fuelled by the stellar performance of US tech stocks.

3.  AIM is missing the mark

The Deutsche Numis Smaller Companies Index tracks main market companies. AIM stocks are dealt with separately - and for good reason. The junior market had another difficult year in 2024, delivering a loss of 4%.

Economically speaking, AIM is important: its contribution to the domestic economy is greater than the UK’s combined agriculture, forestry and fishing sectors. But it has a long way to go in terms of returns and reputation.

• Read: AIM at 30: is it still worth bothering with?

It is also a strange market. Although designed for less mature companies, there are no actual size requirements, meaning household names like Jet2 and Fever-Tree trade alongside loss-making companies worth less than £1m. This makes it a fruitful hunting ground for stock-pickers, but a minefield for passive investors.

AIM’s struggles have been blamed on many things, including over-exposure to ‘fad’ businesses, poor regulation, and the loss of good companies to the main market. The solution to is still proving elusive, however.

4. The market is shrinking

Before the global financial crisis, the London Stock Exchange was fretting that AIM would get too big. It’s now clear that it was worrying about the wrong thing. Between 2000 and 2024, AIM experienced a net loss of companies in all but one year, and numbers are at a 20-year low. The number of main market small caps has been falling too.³ 

Takeovers are part of the problem. According to investment bank Peel Hunt, 30 bids valued at over £100m have already been announced this year, with an equity value of £25bn. And the companies that are being snapped off the public market are not being replaced by new ones: there has been just one IPO since January with a market capitalisation of over £100m.⁴

On the one hand, this suggests there are plenty of bargains up for grabs. However, investors are fearful of a vicious cycle, in which companies go elsewhere and capital follows suit.

How to invest in small caps

The small cap universe can feel like an unfamiliar place. However, there are several active and passive funds in Fidelity’s Select 50 that focus on this part of the market.

For those wanting to invest in small companies from around the world in a fuss-free way, the Vanguard Global Small-Cap Index Fund is an attractive option. This fund is diversified, with around 4,000 holdings from developed markets, and well-priced, with an ongoing charge of just 0.3%.

Other funds have a tighter focus. The Brown Advisory US Smaller Companies Fund, for example - which featured in investment director Tom Stevenson’s fund picks for 2025 - is an unusual play on the US market. The experienced management team favours small, domestically focused American companies, as opposed to the tech mega-stars - although they are still very large by British standards. Meanwhile, the Barings Europe Select Trust invests in small and mid-sized European businesses, excluding those listed in the UK.

It is also possible to home in on the UK market. Fidelity Special Situations is not restricted in terms of size and invests in plenty of FTSE 100 names. However, its value-focus means there are also smaller players in the midst.

Past performance is not a reliable indicator of future returns

Source: Refinitiv, total returns from 31.5.20 to 31.5.25. Excludes initial charge.

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Source:

¹ Morningstar UK Small-Cap Landscape, May 2025
² Deutsche Numis Indices 2025 Annual Review, 16 January 2025
³ Quoted Companies Alliance, 4 June 2025
⁴ Peel Hunt, 9 June 2025