Less liquid parts of the market can suffer from higher levels of volatility due to larger price impacts from buying/selling volumes.
The risks that investors face here are the impact of volatility on a portfolio as well as pricing risks.
Assets that trade less frequently can suffer from price discovery issues.
But according to fund managers, portfolio construction can address these drawbacks via sizing and product selection.
Benedict Tottman, a multi-asset strategist at Charles Stanley, says smaller cap allocations need to be sized appropriately given their level of volatility.
1,000
There are around 1,000 small and mid-cap companies listed on the London Stock Exchange.
He adds: “This is likely to be impacted by the risk level of the mandate as well as the expected risk-adjusted returns/idea conviction.
“Where we have UK mid-cap exposures within portfolios, we have implemented these via an index product. As well as this, providing a cleaner implementation of the beta driven trade rationale, it can also alleviate some of the liquidity-based risks.”
Liquidity is not really an issue with UK mid-cap stocks but it is more of a problem at the bottom end of the market.
There are around 1,000 small and mid-cap companies listed on the London Stock Exchange.
Small caps typically have a market capitalisation of $300mn (£233mn) to $2bn, mid caps are between $2bn and $10bn, while large-cap stocks generally have a market capitalisation of $10bn or more.
Dan Cartridge, fund manager at Hawksmoor, says: “Liquidity is a major risk factor within the UK small-cap market due to the exodus of capital, not just from UK small caps, but from the entire UK stock market in recent years.
“We prefer to focus exposure through investment trusts (fixed pool of capital vehicles) and small, capacity-constrained OE funds. It’s worth remembering liquidity works both ways. When the UK comes back into favour, market prices will adjust extremely quickly.”
Explaining further the challenges of dealing with less liquid stocks, Dan Coatsworth, an investment analyst at AJ Bell, says: “An investor might find a stock that takes their fancy and they buy a chunk. Getting out of that position isn’t always straightforward.
“Whereas, a mid or large-cap stock can be sold at the click of a button, at any point during market hours; there isn’t always a buyer for a small-cap stock. Institutional investors often have to offload positions in small parcels and that is inefficient.”