The UK is back but smaller companies have yet to join the rally. The FTSE All Share had a stand-out year in 2025, delivering a 24% return to investors*, outpacing most other major markets – including the US – over the year. These gains have not yet filtered down into the UK’s small and mid-cap companies, which had another dull year. However, this patriotic choice may also be a shrewd one in the year ahead.
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A strong market, but smaller companies left behind
UK smaller companies weren’t a disaster in 2025. The average fund was up 4.1%, after a 6.7% return in 2024**. It’s just that they were a long way behind almost every other equity asset class, and this type of sluggish return isn’t really the reason anyone takes a risk on smaller companies.
Also, investors had to pick carefully. The gap between the top and bottom fund over the year was 30.5%**, with many good, thoughtful managers among the weaker performers. Managers needed to be in the right places in the market – defence, commodities, or the beneficiaries of merger and acquisition activity. Managers that focus on quality metrics when selecting stocks, such as predictable cash flows, or a strong management team, had a difficult time. This included some small-cap stalwarts such as Aberdeen and Liontrust.
An existential moment for UK small-caps
The discussion around smaller companies has felt existential at various points over the past year. Investors have continued to back away from the sector, despite good operational performance from the companies themselves. International companies and private equity groups have spotted a bargain, and swooped in on many smaller companies, leaving a depleted pool. There have been concerns that UK smaller companies may cease to be a force at all.
Paul Marriage, manager of the Premier Miton Tellworth UK Smaller Companies fund, says: “The UK smaller companies market is in the last chance saloon as we enter a new year. We will either be eye catching and desirable or become a historical footnote. As a historian by training, the desirable eye catchers were the things that made me tick.”
The reasons for small-cap weakness are relatively straightforward. Sentiment has been hit by concerns about the domestic economy. Higher interest rates have also exerted a drag, while the speculation around the Budget in November was unhelpful – both because it deterred investment in domestically-focused UK companies and because it slowed economic growth.
Paul says: “Many companies that had been reliant on a stronger second half have had to admit that this is no longer achievable and downgrades to expectations have been commonplace. For a risk-on sector that is generally viewed as more domestically-sensitive than others, this was a weak market backdrop.”
Turning points, valuations and the case for a comeback
But none of these factors are permanent, and most of them should be reversed. Interest rates have started to come down. Alexandra Jackson, manager of the Rathbone UK Opportunities fund, says: “UK small and mid-cap companies are very negatively correlated to interest rates. If interest rates are rising, these companies are likely to be falling in relative or absolute terms. At the moment, we are seeing the interest rate cycle turn, so that should lead to the reverse. As we get more interest rate cuts, that headwind turns into a tailwind.” The market is confident that the Bank of England will cut rates in February.
The UK economy is recovering, growing by a better-than-expected 0.3% in November. It may be too soon to call a turnaround, but some calm appears to be returning after the Budget. The Chancellor engineered herself some headroom and, while the tax burden remains at its highest level for decades, she avoided putting more damaging taxes on business. There is hope that the Budget may have been a clearing event. It is early days, but UK Smaller Companies funds have seen stronger relative performance since November***.
There are also reasons why UK investors might start to reconsider their low allocations to their domestic market. The previously popular US is looking like an increasingly precarious place to invest, with unpredictable policymaking and soaring valuations. The UK is a good ballast to a US weighting. Alexandra says: “There stocks are something of a tariff shield. With more domestic exposure, you get a little bit of insulation from geopolitical friction. Globalisation seems to be in reverse. If you want to play that trend, UK small and mid-cap companies are a good way to do it.”
If markets move, they could move quickly. The combined market capitalisation of all the companies in the FTSE Small Cap index is £37bn*. Nvidia’s market capitalisation is over £4 trillion. To put that in context, all UK small-cap stocks are less than a 1% of just one of the US mega-caps. It doesn’t take a lot of money to move from one to the other to make a real difference to UK small-caps.
The outperformance of UK small-caps has persisted through history and there is no reason to believe this has changed, with UK stocks trading at a discount to global peers. We’ve also seen growing interest from both domestic and international investors.
Alexandra believes it is going to be tougher and tougher for investors to stay pessimistic on the UK market. “The long-term outperformance of UK small and mid-caps versus large cap is clear. If you want to generate through-cycle alpha in the UK, you need an allocation to this part of the market. You get compensated for the higher volatility in the FTSE 250 and small cap by the higher returns. It’s a long time since we’ve felt that cycle, but the phenomenon does exist.”
After years in the wilderness, UK small-caps may finally be approaching a turning point. Backing Britain could prove to be a smart and timely choice in 2026.
