We look at the basic building blocks of constructing a portfolio and why a diversified portfolio tends to lower the overall volatility of returns. We then explore how a diversified Australian equity portfolio that includes some micro and small cap exposure can help diversify your portfolio. Finally, we take a look at why there are so many securities in both micro and small cap portfolios.
The basic building blocks of asset allocation
The benefit of portfolio diversification is that it can significantly reduce the volatility of returns while still allowing for a strong average return which is the key to building wealth over time.
A key pillar of diversification is your asset allocation decision. Generally, investors should be diversified across all the major asset classes with the goal of selecting asset classes that are negatively correlated through the cycle. Historical examples including the 1991-92 Australian recession (our last recession), the Asian financial crisis (1997/98), the tech bubble (2000), the GFC (2008) and the various European credit shocks (2011-13) prove that diversified portfolios can lower the overall volatility of portfolio returns.
The Strategic Asset Allocation (SSA) decision is the starting point for considering your portfolios asset allocation. After you identify your risk tolerance, the first question an investor should ask themselves is what assets do I include in my portfolio? The answer is that most people will include a mix of cash, fixed income, equities, A-REITs and alternatives (i.e. private equity, infrastructure and absolute return strategies to name a few).
The next question is how much do I allocate to each asset class? The average balanced fund will have up to 60% exposure to equities which includes both domestic and global equities. The remaining 40% will consist of cash, fixed income and alternatives.
The expected return of a typical balanced fund is around 7.0% with an annualized volatility of around 7.0%. This means investors should expect a negative annual return once every 6 to 7 years on average. As a comparison, if your portfolio was 100% in equities, you would expect an average return of 10% but a negative annual return every 4 years. In this example, you can see that although equities offer a higher average return, it is much higher volatility.
Building a diversified equity portfolio
In addition to the benefits of diversifying asset classes, there are also benefits to diversifying with in asset classes including with in equities.
Given the media’s attention of large cap stocks like the banks and Telstra, it is not surprising that many investors only focus on these large cap stocks when building the equity portion of their portfolios.
However, only investing in large cap companies can add risk to a portfolio that some investors may not be aware of. For example, the large cap ASX 100 index composition is heavily weighted to Financials ex-REITs (40% by market capitalisation) and has a relatively low weight to Consumer Discretionary (only 3% by market capitalisation). Therefore, if you only invest in ASX 100 stocks you may have systematic sector biases in your portfolio that may not be optimal over the longer term.
Small and micro cap stocks can help you further diversify your portfolio
Exposure to micro and small cap stocks can provide extra diversification for your portfolio and can also enhance your longer term expected returns. Micro cap stocks generally have a market cap of between $30m to $300m, while small cap stocks will be in the ASX Small Ordinaries Index and have a market cap up to $2 or $3 billion.
The small and micro cap sectors give investors exposure to faster growing companies and industries of the future including technology, biotech or new service sectors. Often, trying to find exposure to these types of industries or high growth companies in the large cap sector is difficult as many large cap companies operate in relatively mature industries.
Over the past year, there have been some significant earnings downgrades for the large cap sector in Australia. This has been reflected in the flat to negative earnings growth estimates for that segment of the market. But moving down the market capitalization range we find that mid, small and micro caps are offering 6%, 14% and 18% growth respectively.
Some good examples of successful small and micro cap companies that have returned significant value to shareholders are REA Group (REA), Magellan Financial Group (MFG), HUB 24, (HUB), Catapult Group (CAT), SG Fleet Group (SGF), BT Investment Management (BTT), Bursons Group (BAP), OzForex (OFX), Veda Group (ED), Mantra Group (MTR), Lovisa Holdings (LOV), QMS media (QMS), Mayne Pharma Group (MYX) and Domino’s Pizza (DMP) to name a few.
The question is how much of your portfolio should you allocate to the small and micro cap segment of the equity market?
The answer will clearly depend on your risk appetite and targeted expected returns, but a basic rule of thumb is up to 30% of your domestic equity portfolio. Combining this with your mid and large cap holdings will ensure additional earnings and return diversification while maintaining an appropriate expected return.
In addition to sector and industry diversification, exposure to small and micro cap stocks can also add some economic diversification as well. Generally, large cap stocks are the first to outperform in the early stage of an economic recovery. Large cap stocks are generally more responsive to lower interest rates and are able to take costs out quicker than small cap stocks which usually have relatively lean business models. However, as the economic recovery matures, benefits start to flow to broader sectors of the economy which generally benefits the small and micro cap sectors which are more dependent on the domestic economy.
Looking forward, most economists expect an economic recovery in 2016 which would be supportive for small and micro cap stocks. However, there are some sectors that should continue to struggle in the small cap sector including resources and mining services. These sectors face structural headwinds and bank lenders are not keen to increase their exposure to this sector limiting their ability to get future funding. This does not mean you should have zero exposure to these companies, but rather you should be very careful about which companies you select for your portfolio. At this stage of the cycle, there may be some opportunities for companies with low gearing, solid high-quality contracts and for companies that can benefit from lower energy prices. Systematically identifying these small and micro cap companies which offer strong returns can be difficult and time consuming.
The risks of investing in this sector of the equity market is higher compared to investing in the top 100. These smaller companies tend to be at the early stage of their life-cycle often with exposure to only a single product or single mine. This sector requires significantly more workload to uncover the quality of the company’s balance sheet, the core drivers of the business model, the key person risk and structure of the management team and the board (governance).
From time to time small and micro cap companies undertake equity raisings or IPOs which each require careful analysis and scrutiny. A prudent investor would need to take an even deeper deep-dive into the risks and opportunities presentable in a small or micro cap business model.
This is why fund managers in this space tend to have very experienced portfolio managers who have managed through a number of market corrections and relatively large investment teams which are required to systematically exploit value in this sector.
Being across the large number of stocks in this sector can be a daunting prospect for some investors which instead opt to use a professional fund manager with the required resources. Although some investors have opted to gain exposure to this sector via passive index based ETFs, this has proven to be a suboptimal allocation given the sectors large divergence of returns between stocks and sectors. Selecting the appropriate stocks in the small and micro cap sectors is critically important.
Outlook for micro and small caps looks promising
So far, the economic and market recovery has mainly benefited the larger companies which are well into their cost and capital management phases. They are repairing balance sheets and benefiting from the lower AUD and the lower interest rate environment. The next phase of the recovery will be in the small and micro cap sectors which will begin to feel the benefit from the improving domestic economy. We are expecting strong growth from the technology, biotech and new service sectors. However, there are some sectors that should continue to struggle including resources and mining services given these sectors face structural headwinds.
In summary, diversification across and within asset classes can help achieve a more optimal risk adjusted return over time. Exposure to the micro and small cap sectors can provide sector, industry and economic diversification to a portfolio. But there are additional risks to investing in this segment of the market and a prudent option is to utilise a professional funds manager with the appropriate systems and resources.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
