As investors assess their results for the year and plot a course for 2020 and beyond, many will be tempted to dump those funds that tanked in 2018 and focus on the outperformers.

But this review of the greatest turnarounds for Australian small- and mid-cap funds suggests some of the best performers next year could be those that disappointed the most in 2019.

This highlights the folly of deciding to sell a fund purely on the basis of lagging returns over a single year.

The biggest reversal in performance since last year, which was something of an "annus horribiliis" for equity markets everywhere, was Celeste Australian Small Companies (6419).

In the fourth quarter of 2018, global stocks suffered their worst three months since 2011 and their eleventh worst period in almost 50 years. The MSCI World Index dropped from 2,021 points at the start of September to 1,883 by 31 December, capping a year that saw the index's value dive more than 10 per cent.

Australia's small cap benchmark fared slightly better, falling 7.5 per cent in 2018 – most of which was due to the negative-12.4 per cent return I the December quarter.

Small-cap fund performance 2018 vs YTD 2019

small cap funds

Source: Morningstar Direct

Celeste Australian Small Companies (6419)

Analyst rating: Bronze Medal

Morningstar rating: Two-stars

The Celeste strategy in 2018 saw the greatest performance dip among its peers covered by Morningstar fund research. The team led by portfolio manager Frank Villante delivered a loss of 13.8 per cent for the year ended 31 December, and negative-16.4 per cent in the fourth-quarter.

But the fund has bounced back this year, beating comparable offerings from Pengana, NovaPort and Perpetual to return 28.72 per cent year-to-date.

Morningstar likes Celeste's low portfolio turnover and its high conviction approach, but investors should be aware this can be a millstone at times if a stock call doesn't bear out.

The portfolio can be prone to taking significant positions in various sectors and specific companies. Morningstar fund analyst Michael Malseed notes the fund has favoured industrials for a long time, and has been under-weight resources for around nine years.

Its largest holding was funeral services company Invocare (ASX: IVC) as at 31 July this year. Invocare is regarded by Morningstar as a wide-moat company, given its almost unassailable dominance of Australia's funeral industry.

The company is currently trading at a handy 20 per cent discount to the fair value estimate set by equity analyst Mark Taylor. Invocare's last closing price was $12.85, versus a Morningstar fair value estimate of $16.

Celeste's analyst team has dialled up its holding in the company over the last 12 months. From a portfolio weighting of 2.58 per cent in June last year – its 19th largest position – Invocare's 6.32 per cent weighting as of 31 July is the fund's largest single exposure.

The ASX Small Ordinaries only holds a weighing of 0.63 per cent – a good example of the fund's active stance, which pays little heed to the benchmark.

This is a key distinction between small-cap and large-cap funds. Scanning the top holdings of the biggest large cap strategies reveals a lot of cross-over and a propensity to track benchmark movements – as I found in last week's Fund spy examining allocations to Australia's largest miners.

Small cap managers need to sharply focus on individual companies rather than being guided by the index – which often features some more spurious start-ups among the quality companies.

Pengana Emerging Companies (12260)

Analyst rating: Silver Medal

Morningstar rating: Four-stars

Pengana Emerging Companies has also pulled off an impressive come-back this year, returning 25.5 per cent after losing 9 per cent in calendar 2018.

Lifestyle Communities, a property developer focused on Australia's ageing demographic, was one of Pengana's top holdings as of 30 April, with a 4.9 per cent holding.

Listed property company Charter Hall has a 4.5 per cent weighting, and its portfolio also includes biotechnology, resources and technology names.

Local tech darlings WiseTech (ASX: WTC), Afterpay (ASX: APT) and Altium also feature – though weightings haven't moved significantly over the year.

Morningstar fund analyst Ross MacMillan notes the fund has one of the strongest track records among local mid- and small-cap managers. The Pengana strategy has been a top performer for more than 60 per cent of the periods tracked since the fund started back in 2004.

Last year was a difficult one, as several stock holdings failed to perform including Bingo – a company that Morningstar equity research has recently added to its stable.

Perpetual Smaller Companies (4363)

Analyst rating: Neutral

Morningstar rating: Three-stars

Perpetual Smaller Companies' 2018 performance fell slightly behind Pengana's, returning a loss of 9.1 per cent.

But it has returned to strongly positive territory, returning 18.17 per cent in the year so far.

Morningstar's Malseed notes its holding of southeast Asian casino operator Donaco was the biggest drag on performance in the first-half of 2018, before Perpetual exited the position.

Its performance was also held back by the absence of Afterpay and Wisetech, which lifted the annual return figures for many managers last year.

Malseed suggests the fund's style means it is more likely to struggle in bull markets than some of its peers. But these same attributes should position it well in a downturn.

However, he is cautious about the fund's size, given its funds under management has ballooned to $4 billion – despite having slimmed down slightly due to some withdrawals by institutions in the first half of this year.

Being too big can slow down decision-making, an important trait in the small-cap space – and Morningstar continues to monitor the situation.

UBS Australian Small Companies Fund (11595)

Analyst rating: Bronze Medal

Morningstar rating: Four-stars

The UBS fund – which is now managed by the team behind Yarra Small Companies after UBS exited active funds management in Australia at the end of 2018 – is the clear performance leader year-to-date.

Under the leadership of portfolio manager Katie Hudson – one of the few women heading Aussie small cap funds – it has returned 35.3 per cent.

Scrolling through its top six holdings reveals some impressive returns for the year. Mining services firm Imdex and food retailer Collins Foods share prices have increased by more than 40 per cent during 2019 so far.

And healthcare firm Nanosonics also contributed some impressive gains, its share price more than doubling this year.

NovaPort Smaller Companies (9140)

Analyst rating: Silver Medal

Morningstar rating: Two-stars

NovaPort Smaller Companies fund rounds out this list, returning 25.5 per cent year-to-date in 2019, after turning in a loss of 8.6 per cent last year.

Morningstar fund analyst Andrew Miles says it is one of his favoured value-orientated small cap managers, but notes its falling assets under management is slightly worrying. From $1 billion in mid-2018, its holdings have fallen to $550 million as at 30 October. 

The team runs quite a concentrated portfolio of between 30 and 35 companies, in a strategy that veers away from the Small Ordinaries index and its peer group.

Its top holding as at the end of August is consumer lending company Credit Corp Group, with a weighting of 5.4 per cent.

The fund's performance last year was hurt by the absence of WAAAX players such as Wisetech, Altium and Afterpay – which didn't make the cut because of NovaPort's strict discipline in avoiding companies with elevated price-to-earnings ratios.

But Credit Corp Group (ASX: CCP) along with miners Gold Road and Independence Group served the portfolio well this year, their share prices up by 75 per cent, 80 per cent and 56 per cent, respectively.