UK Small Caps Have Had a Rough Decade. Is the Tide Turning?

Small UK companies have a long record of beating their bigger rivals. Research by Elroy Dimson, Paul Marsh and Mike Staunton for UBS, covering 1900 to the end of 2025, found that the smallest shares in the FTSE beat the wider market by roughly 2.5% a year on average. That's a meaningful edge over more than a century, which is why the last decade has been so frustrating for anyone holding them.

A lost decade, measured in percentage points

Since 2010, the pattern has flipped. Cassie Herlihy, portfolio manager of the Henderson Smaller Companies Investment Trust, describes it as "something of a lost decade for UK small caps." Depending on which index you use, the sector has trailed the wider market by roughly 5% to 6% over the past ten years.

Here's the thing, though: the mood may be shifting. Henry Ince, an equity strategy analyst at Morningstar, argues that a few signals point to an "inflection point." Those include early signs of improvement in the wider economy, government efforts to nudge institutions, especially pension funds, into UK shares, and a wave of takeovers. None of these guarantees a turnaround, but together they're hard to ignore.

Why small caps fell out of favour

Herlihy's view is that the slump has been driven far more by outside forces than by any decline in the quality of the businesses themselves. The 2016 decision to leave the EU is a good example. In her telling, the UK "essentially fell out of favour with international investors, who increasingly looked elsewhere."

Then came Covid. Businesses that depended on the domestic market took some of the hardest hits, as smaller retailers, restaurants and leisure companies lost their revenue almost overnight. The pain didn't stop when the pandemic eased. The post-Covid readjustment, Russia's full-scale move into Ukraine and the Liz Truss mini-Budget all pushed inflation and interest rates higher. That made it more expensive to borrow for growth, and smaller firms, which tend to be focused on expansion, felt that pressure more sharply. Political instability added to the problem by creating what Herlihy calls "uncertainty and a lack of confidence," which made it harder for businesses to make decisions.

Revenue mix matters here too. According to Morningstar's indices, UK small caps earn around 50% of their revenue from the UK on average. Larger counterparts get only about 20% to 25% from home. When the domestic economy struggles, smaller firms have fewer overseas sales to fall back on.

The pension fund exodus

Institutional money has been leaving too, and that's arguably the biggest structural issue. Georgina Brittain, manager of the JPMorgan UK Small Cap Growth & Income Trust, notes that twenty-five years ago British pension funds held about half their assets in UK equities. That share has now fallen below 5% as money has flowed into global benchmarks instead. She calls this a "massive outflow of money," and it has weighed on prices.

Tax changes haven't helped. Vishal Bhatia, senior fund manager of the J O Hambro Capital Management (JOHCM) UK Dynamic Fund, points out that most shares on the Aim junior market were once exempt from inheritance tax. That exemption no longer applies, which adds another reason for investors to look elsewhere.

Bhatia also points to something less technical: patience. Small-cap investing requires time, and that's hard to maintain when social media delivers a constant stream of news, creating, in his words, "more noise than investors have ever encountered."

Valuations that look stretched in the wrong direction

The flip side of the slump is price. Roland Arnold, portfolio manager of the BlackRock Smaller Companies Trust, describes valuations as "exceptionally low, both in absolute terms and relative to other markets." He says they resemble levels "typically associated with periods of extreme economic stress," even though the underlying situation "does not justify such depressed levels." The UK as a whole already looks cheap by global standards, and smaller companies trade at a further discount within that.

Cheap doesn't automatically mean rising, though. Arnold is clear that low valuations alone won't guarantee a recovery. The sector needs a catalyst, and that's hard to pin down in advance. His argument is that prices have fallen so far that even a "modest improvement" in confidence "could be enough to encourage investors to reassess the opportunities." That's the kind of setup where sentiment can move faster than fundamentals.

Herlihy thinks the broader economy could help change investors' minds. The "cautious optimism" that greeted the start of the year was dented by the conflict in the Middle East, but she suspects that shock has mainly delayed interest-rate cuts rather than cancelled them. Inflation is "much less entrenched than it was in the immediate aftermath of Covid," which gives policymakers more room to focus on growth. Company and household balance sheets also remain strong, which supports spending.

Bhatia adds a bond-market angle. If investors trust the chancellor's commitment to fiscal prudence and fully funded spending, long-term borrowing costs should ease from their current elevated levels. A calmer gilt market would, in his view, "give equity investors the confidence to commit long-term capital."

Ince is more upbeat still. Several companies seen as bellwethers for consumer spending, including Halfords, Young's and Greggs, have recently reported strong figures and raised their expectations for the near term. Consumer confidence has reached a two-year high, and GDP growth, though not especially strong, is "not awful" either. His read: "We are already seeing some green shoots of recovery in the small cap market, which has outperformed larger caps over the last six months."

Pension money could turn the tap back on

Helen Curtis, a partner at Devonshires, sees institutional flows as a potential driver of a revival. Under the Mansion House Accord, major pension providers have committed to investing 10% of workplace pension portfolios in productive assets by 2030, with at least 5% earmarked for UK investments. Curtis suggests the pension sector may not have much choice but to lean into UK shares.

Pressure could increase. Curtis describes two possible routes. The "carrot" would involve incentives such as lighter rule burdens and reforms to listing requirements. The "stick" could mean raising the existing voluntary target or turning it into a mandatory minimum.

Herlihy considers a formal mandate unlikely in the near term. Still, she says there's "enough noise around this that some more of the forward-thinking pension funds may move ahead of the herd," and others might follow. Some pension-fund managers are already questioning the assumption that the US market will always outperform the UK. A growing number are viewing the UK as a "relatively safe, attractively valued way for investors to diversify" away from the AI boom.

She also argues that a flood of new money isn't necessary. "Just stemming the persistent outflows would be enough to start underpinning valuations," Herlihy says, particularly because it takes little money to move prices in a less liquid market like small caps. Brittain makes a similar point from the other direction: pension-fund holdings of UK shares are so low that "any increase would provide a significant boost."

Takeovers are doing much of the heavy lifting

The most immediate catalyst may be mergers and acquisitions. Cheap valuations have pushed up the number of smaller companies being taken over. Brittain says private-equity firms have mostly driven this boom, and that they've been getting "some of the bargains of their lives." More recently, large corporate buyers have joined in, snapping up "some really cheap rivals." The split between the two groups has moved toward something like 60:40 between private equity and large firms.

The premiums are striking. Ince describes some as "eye watering." Bhatia reports that over the past three years, nine small-cap holdings in the JOHCM UK Dynamic Fund were acquired at an average premium of around 67%, with the highest reaching 169%. Many UK-focused fund managers and investment trusts are, in Ince's words, "almost having to apologise to their investors" for selling companies they hoped to hold for the long term. Still, he argues that a well-informed buyer willing to pay a 40%, 50% or even 80% premium "tells you how much of a mispricing there might be."

The numbers back this up. Henry Norton of Arbuthnot Latham says deals involving FTSE Small Cap constituents this year have totalled about £3.9 billion, roughly 10% of the index's value. Another £2 billion of activity has taken place across Aim. Across the wider UK market, takeover premiums have averaged around 45%, which shows how much strategic and private-market buyers are willing to pay above public-market prices. Share buybacks are another route for companies to take advantage of low valuations, and Norton notes that firms are increasingly using them to support returns.

Separating bargains from value traps

Ince's view is that the combination of undervaluation and an improving backdrop makes UK small caps look attractive. Investors still need to be picky, though. Some things are cheap for a good reason, and avoiding these "value traps" takes work. Arnold makes the case that research pays off, since the UK smaller-companies market "remains an under-researched area" and a "bit of legwork can pay dividends."

Arnold points to food production as a sector worth examining, because demand tends to hold up regardless of the economic backdrop. Infrastructure businesses often have long-term order books that "provide greater certainty over future revenues." Capital-goods companies could also benefit "from an increase in capital expenditure, following several years in which management teams have held back on investment."

Curtis highlights specialist healthcare, diagnostics and medical-technology companies, along with firms supplying the tools, software, infrastructure and specialist services that enable digital transformation. She also notes that some names have sold off on fears of disruption from AI. That threat is real, in her view, but it has been exaggerated. Smaller companies are often more agile at adapting and quicker to take advantage of change than their larger peers.

Bottom-up beats betting on a sector

Rather than hunting for promising sectors, Norton suggests focusing on individual companies with "fundamentally strong businesses whose valuations have fallen primarily because capital has left the asset class rather than because the underlying businesses have deteriorated." He points to strong cash generation, high margins, low financial leverage and management teams capable of driving their own improvement. Those traits, he argues, let companies prosper without relying entirely on a strong UK economy, and they can also make firms attractive takeover targets.

Nikki Martin, senior portfolio manager of global equities at Sarasin & Partners, agrees that the company matters more than the industry it sits in. She highlights a company's ability to dominate a specialist market overseas as a sign of good management. Some of these firms, she says, are still "priced on UK multiples, even though they are earning international revenues."

Herlihy's ideal small cap is a firm that is "masters of their own destiny, with self-help levers they can pull to drive growth, manage costs and show resilience whatever the broader economy is doing." That's a useful test: can the business keep moving forward without a favourable market wind behind it?

What the funds in the piece illustrate

The article points to a couple of funds as examples of how investors can access the sector. These are illustrations of different structures, not recommendations, and past performance doesn't predict future results.

The first is an exchange-traded fund, the iShares MSCI UK Small Cap UCITS ETF, which tracks the MSCI United Kingdom Small-Cap Net index. It holds 193 companies. Its largest holdings have market capitalisations of around £5 billion, which some definitions would classify as mid caps, but the median holding is around £1.3 billion. The average price-to-earnings ratio is 14.5 times, and the total expense ratio is 0.53%.

The second is an actively managed investment trust, the JPMorgan UK Small Cap Growth & Income Trust. It targets fast-growing firms with market capitalisations between £100 million and £4 billion, aiming for a balance between "value and momentum." Its shares trade at a discount of 8.7% to book value, and the article reports a ten-year total return of 199.4%, against 66.4% for its benchmark, the FTSE Small Cap excluding investment trusts. Its ongoing charge is 0.75%, and it is widely expected to merge with the Aberdeen UK Smaller Companies Growth Trust in the near future.

The piece also profiles several individual companies across construction-related materials and services, beauty technology and payments. Their valuations, according to the article, range from roughly 10 to under 18 times 2027 earnings. Each one carries its own company-specific risks, and the piece doesn't suggest any of them are suitable for every investor.

What to watch next

The clearest signals to track are pension flows, the pace of takeovers and whether the UK economy keeps delivering modest improvement. If pension funds slow their outflows, or if policy pushes them toward UK shares, that could matter far more for a small market than for a large one. Until then, the sector's future depends on whether confidence catches up with cheap prices.

For individual readers, this is general information rather than personal advice. Small companies tend to be more volatile than large ones, and their shares can be harder to buy and sell quickly. Before acting, think about your time horizon, your tolerance for big swings, how much you already hold in the UK and whether a broad, low-cost fund fits better than picking individual companies.