THE season of goodwill often brings good news for stock markets. At this time of year there is typically a pick up in share prices known as the Santa rally, which is then followed by the so-called January effect.

Although not infallible, more often than not a number of factors support share prices. Smaller companies, in particular, can benefit, driven by private investor interest, share tips and lower stock market trading volumes over the holiday period.

But there are some risks now in smaller companies that suggest investors should think carefully this year.

British Christmas holidays have become extended, with market-makers now much less willing to take on risk over the year-end.

That means the process that sees stockbrokers squaring the books and investors tidying up portfolios – window dressing, in other words – starts from early December.

Buying or selling shares can be difficult as business winds down. Adding to the risks, January share tips often draw private investors into paying up for shares, which is a profitable exercise for market-makers.

Now there are signs that a bigger stock-market shift is under way that may see smaller companies move out of favour. This has been driven by reaction to the liquidity problems faced by Neil Woodford’s funds as well as an increased regulatory focus on ensuring unit trusts are well positioned to pay back investors.

Added to this, two years after the regulation that cut stockbroking commissions, the quality of stockbroking research on smaller companies has fallen.

There is more risk now that problems in companies might be hidden for longer. Over the last 18 months smaller companies have begun to lag medium-sized businesses, known as mid-caps. Previously they performed similarly, both better over the long term than the biggest companies.

The new regulation sharply cut equity research budgets. The cost burden moved to investment management groups and commission fell, putting downward fee pressure on investment banks and stockbrokers.

Fund managers negotiated much tougher terms, and City analysts found that much of their research output was simply not valued. This has fundamentally undermined the business model of smaller company stockbrokers, moving them to focus on researching only their own listed-company clients.

This means an increasing proportion of smaller company research is inherently flawed, conflicted by fees from those corporate clients.

This brings a bias towards favourable comment, when a sell recommendation could jeopardise the corporate relationship.

Much small-cap research now looks much more like promotional investor relations material than critical analysis.

Less professional research into smaller companies makes questionable accounting and stock market blow-ups more likely.

This drop in research quality should give more opportunity for investing institutions to fill the gap. But dealing can be difficult for anything other than very small funds. Even where institutional investors identify an opportunity in an undervalued business, it may not be easy to buy enough stock to make the work worthwhile.

When liquidity drains away, interest fades unless a company is exceptional, the shares have a very high dividend yield, or are extremely cheap.

The positive for UK shares is that international investors could return when Brexit is clearer.

Smaller companies tend to have more exposure to the British economy, typically in areas such as housebuilding, property and consumer services. But many medium-sized businesses offer this exposure while also having greater ease of dealing and more research. Investors might consider moving up in stock market size, following the path of many institutional investors currently.

There are some unique growth businesses in the small company sector, but investors should do their own independent research.

Seasonal patterns and the possibility of a Brexit rebound could give a short-term fillip for smaller companies. Looking to the medium and longer term, investors may need to rebalance portfolios to reduce any risks.

Colin McLean is managing director at SVM Asset Management.