One small-cap fund manager after another this year has argued for investors to increase their portfolio allocation to small-cap equities.
Yes, fund managers pushing their own book hardly surprises. But small-cap managers had a solid case that investors should increase exposure to smaller stocks, even if they had made similar arguments over the past few years.
Australian small-caps have underperformed large-caps for more than a decade, such has been the market’s preference for large companies. During and after the Covid-19 pandemic, risk-averse investors preferred larger stocks.
The S&P/ASX Small Ordinaries Index, which measures stocks ranked 101-300 by market capitalisation, has an annualised total return of 7.5% over 10 years, S&P data shows. In contrast, the S&P/ASX 100 Index has returned 9.3%. That’s a big difference when compounded over 10 years.
The performance gap has widened in the past three years. The Small Ords’ annualised total return of 0.1% badly lags the ASX 100’s total return of 9.11%.
Some small-cap managers have done much better than the Small Ords due to their skill in spotting undervalued stocks in volatile markets. Still, in terms of indices, the smarter play has been sticking with large-cap stocks.
The long-term underperformance of small caps is perplexing. Small-caps tend to outperform large-caps when interest rates fall, the Australian economy strengthens, and investor risk appetite rises.
The market expects interest rates to fall early next year, our economy looks like it will avoid recession, and the local share market trades near a record high.
One could expect portfolio asset allocators to direct more funds towards small-cap equities in anticipation of rate cuts next year and better economic conditions. But on a year-to-date basis, small caps still lag as the Morningstar chart below shows.
Chart 1: Australian small caps versus top 2o stocks
What gives? I put small-cap underperformance down to a few factors. First, expectations for rate cuts have been pushed back due to persistent inflation. Economic tailwinds for small caps are taking longer than expected to arrive.
Second, the boom in index investing via Exchange Traded Funds favours large-caps, as more money is allocated to large-caps with a higher weighting in indices. Many small caps in this market don’t benefit from passive money flows, even though their aggregate valuations arguably improve as capital inflows from ETFs push the market’s largest stocks higher.
Third, the Initial Public Offering (IPO) market remains moribund. Apart from, Guzman y Gomez, a mid-cap stock, there has been little muted interest in IPOs for the past few years. That’s bad for small cap investing.
Fourth, index methodologies also explain the performance gap. Care is needed in comparing indices. By market weight, the ASX 100 is dominated by a handful of banks and mining stocks. Several key bank stocks have rallied.
The Small Ords, in contrast, has far less exposure to banks. The finance sector comprises 11% of the Small Ords; it is 33% for the ASX 100 Index.
The Small Ords Index also has more than double the weighting in consumer discretionary retailers that are struggling in this economy. Clearly, differences in index composition explain a big chunk of the performance gap with large caps.
So, is it time to lift exposure to small caps? Yes and no. The Yes is for small caps generally. With rates falling in the US, Europe and the United Kingdom – and probably Australia in the first quarter of 2025 – tailwinds for small-caps are building.
The No answer is for Australian small caps. I like small-caps right now but prefer global small- and mid-cap stocks to local ones.
That’s not to say there aren’t great opportunities in Australian small-cap equities or asset managers capable of finding them. This market has some terrific small-cap managers who run unlisted and listed small-cap funds.
But from an asset-allocation perspective, I prefer global small-cap equities. Other advanced economies are much further ahead with their rate cuts, and I’m not convinced rates in Australia will fall as soon or as quickly as the market expects – a position I outlined in last week’s column.
Higher rates for longer and a local economy that is barely growing are bad news for small cap investing. Some small caps will do well, but I can’t see conditions for smaller Australian industrial companies improving in a hurry.
Local listed funds that provide exposure to global small caps are relatively limited. Here are two to consider:
- iShares S&P Small-Cap ETF (ASX: IJR)
IJR aims to track the performance of the S&P SmallCap 600 Index – a useful barometer of small-cap equities in the US.
Small caps in the US are much larger than those here due to the size of that market. The largest stock in the index is capitalised at $8.4 billion and the median size is just over $2 billion. The index also includes some micro-caps.
The SmallCap 600 Index has a reasonably high weighting to financials (19%) and a relatively low stock weighting to materials stocks (5.5%).
In Australian-dollar terms, the index has an annualised return of 12.6% over 10 years – well up on the Small Ords’ 7.5% return over that period.
As in Australia, US small-cap stocks have lagged US large-cap stocks. But US large-caps have delivered higher returns, on average, than Australian small-caps – a trend I can’t see changing in the next 6-12 months.
With the US more advanced in its rate-cutting cycle than Australia, tailwinds for US small-caps will be stronger than comparable trends here.
IJR has delivered an annualised return of 5% over three years. The ETF is poised to deliver returns as US rates cuts aid small-cap performance.
IJR’s annual fee is a low 0.7%. The fund is unhedged for currency movements, meaning investors are exposed to currency risk.
Chart 1: iShares S&P Small-Cap ETF
Source: Google Finance
- Fidelity Global Future Leaders Active ETF (ASX: FCAP)
Investors who believe small-cap investing is best served through stock picking rather than index investing should use active funds over ETFs.
Investors who seek listed small-cap global funds have few choices. Options include the Vaughan Nelson Global SMID (managed fund) (ASX: VNGS) and the new Fidelity Global Future Leaders Active ETF, an active ETF on ASX.
Launched in May 2024, FCAP looks like a useful tool for small-cap investors who seek global exposure. The fund holds 40-70 small-to-mid-cap global companies, handpicked by Fidelity’s global investment team.
Almost 60% of FCAP is invested in US equities, a market I favour. By sector, about 40% of FCAP is invested in industrial and information technology stocks.
One of FCAP’s largest overweight positions – Brown and Brown, an insurance broker that specialises in risk management – has rallied this year. So, too, has NVR, a home builder that is another key overweight position in FCAP.
I like the look of FCAP’s portfolio and its leverage to Fidelity’s large global research team. Although it’s early days for FCAP as an active ETF on ASX, the fund is off to a good start and helps fill a gap for global small-cap exposure in this market.
FCAP’s annual management fee of 1.1% is reasonable for an active small-cap equity fund, particularly as there are no performance fees. The fund is unhedged for currency movements, making currency risk a consideration.
Chart 2: Fidelity Global Future Leaders Active ETF
Source: Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 16 October 2024.
