Richard Newell hears it for the specialist funds

The message from managers of European smaller company funds is a familiar one. While 1996 was generally a good year, 1997 was most definitely not. The performance figures show quite a number of groups producing positive returns, including some respectable double digit gains from the likes of Fleming and Mercury. But overall, the sector under-performed. Fund managers suggest this is part of the argument for buying into smaller companies at thistime.

Daniele Serruya, who manages the European Smaller Companies fund of the Luxembourg-registered Schrod-er International Selection umbrella, says, At various times, these stocks will underperform. If you look at a three-year view, we can demonstrate that small companies can outperform. But during that time, you will have periods of massive underperformance, followed by periods of massive outperformance. That is the nature of the sector."

Invesco's Andy Crossley comments that the group's Jersey-registered European Small Company Fund "may be appropriate for aggressive investors seeking growth and international diversification". In its promotional material, Invesco produces a diagram to illustrate how this fund compares to others in its range. It is clearly at the high risk/high return end of the spectrum and is not alone in this.

Last year, Schroders' European team was punished for its strategy of investing only in growth stocks, but it hopes to benefit from this approach in 1998. Serruya says: "We like to have a few recovery stocks in the portfolio, but essentially we are growth oriented. Large caps are seen to be overvalued and with the picture in Asia, small caps should have a good year, particularly quality/growth companies, if interest rates remain stable."

Takeovers and mergers have been a feature of the small-cap marketplace. But according to Serruya, the Asian crisis has added a dose of realism to all the talk about globalisation: "That trend has been overplayed, and as a result small companies have become relatively cheap."

According to Mercury's Stephen Cohen, small caps have been out of favour in Europe for three years, mainly because of "some dramatic developments among large cap companies and the general boom in blue chips. Small caps are therefore relatively attractively priced."

The Mercury European Opportunities Fund has been going for 11 years and, like many of its contemporaries, follows a bottom-up approach. The fund was originally managed by Consuelo Brooke and she still heads the team of investment managers which runs around $3bn of European portfolios, mainly for US pension fund clients. The fund is now run by Ed-oardo Mercandante, who has about $400m under management and tends to hold between 75 and 90 stocks, with not more than 2.5% of the fund in any one holding.

The portfolio weightings of this sector's leading funds are quite a contrast. The top performing fund, Luxembourg-registered Fleming European Discovery, is fairly evenly spread across the UK (16%), France, Italy and Switzerland (12%). Fidelity's European Smaller Companies has almost 30% in UK stocks, as does Invesco.

Cohen says Mercury aims to buy and hold companies "where we feel the balance sheet is sound, where we have met the management and feel we un-derstand their strategy, and where there is a chance of good growth". The most popular areas, and those producing the best growth, are in sectors such as outsourcing service, leisure, technology and health care. So how do you beat the volatility? Cohen suggests: "This is definitely a fund that is best held for the long term, and over three years we would expect to produce good performance. But we try not to worry about the risks. Luckily these companies tend to have very little correlation so you can eliminate some of the stock-specific risk."

According to Invesco's Crossley, the outlook for smaller caps is encouraging: "The process of converging interest rates in the run-up to EMU has already started to produce a pronounc-ed difference in the rate of growth of economies in Europe. There are some good investment opportunities in the faster growth economies such as Ireland, Spain and Italy." Irish stocks have been boosted by the 6% cut in the corporate tax rate. Key sectors for the fund are health care and services, where earnings have a high level of visibility and growth rates are rapid.

But a recovery in small cap fund performance is in the hands of the markets. saysCohen: "If larger companies continue to produce the exceptional growth due to the unlocking of shareholder value, then smaller companies will underperform. As many of them are new companies, they don't have those reserves of value to be unlocked. We certainly think that small caps are attractively valued. If you look at the sector's historic valuation, it is right at the bottom of the trading range.""