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Smart beta offers big opportunities in small caps

Arian Neiron  |  28 Mar 2017Text size  Decrease  Increase  |  

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It should come as no surprise that ETFs have moved into the limelight and are providing attractive ways for investors to achieve low-cost small-cap exposure.

 

Investors continue to gravitate towards small-cap companies for growth, particularly as the resources sector continues to recover. However, finding the right small-cap strategy is becoming more challenging for investors as active managers increasingly fall behind the benchmark.

Over the past one and three-year periods, over 80 per cent and 60 per cent of small-cap active funds were outperformed by the S&P/ASX Mid-Small Cap benchmark respectively, according to the latest S&P Dow Jones SPIVA Australia Scorecard for year-end 2016.

The rebound in small-cap resources stocks has coincided with the underperformance of active small-cap managers, indicating that picking resources stocks is no easy gig.

Active managers need specialist knowledge and considerable research in the resources sector to effectively pick which resources companies are going to perform well. Previously, when resources companies were underperforming, it was easier for active managers to avoid the sector, however this is no longer the case.

The following table shows the percentage of Australian equity mid and small-cap funds that were outperformed by the S&P/ASX Mid-Small Index.

 

table

Source: S&P Dow Jones Indices LLC, Morningstar. Data as of 31 December 2016. Table is provided for illustrative purposes. Past performance is no guarantee of future results.

 

Smart beta steps into small caps

It is no surprise that passive index funds, such as ETFs, have moved into the limelight and are providing attractive ways for investors to achieve low-cost, diversified exposure to the small-cap sector.

More recently, innovation in index design has led to the development of smart-beta indices. Smart-beta ETFs offer the best of both worlds, aiming for outperformance like an active strategy while providing the low-cost, transparent, and rules-based attributes of a passive strategy.

Factors in smart-beta strategies have been identified as persistent drivers of return that explain how securities behave.

For example, VanEck's Small Companies Masters ETF (ASX: MVS), which tracks the MVIS Australia Small-Cap Dividend Payers Index, is a smart-beta ETF which is specifically designed to invest in small companies on the ASX that are liquid and pay out dividends.

Screening for liquidity and dividends helps identify more stable businesses that demonstrate value and quality, which is paramount in the small-cap sector.

Dividends are empirically linked to determining stock values and future earnings. It also results in a well-diversified portfolio of small-cap companies across sectors including the resources sector and without any stock concentration risk.

In 2016, MVS returned 14.36 per cent. In comparison, Australian mid- and small-cap funds delivered an average return of only 9 per cent over the same period.

Looking at the longer term, the MVIS Australia Small-Cap Dividend Payers Index has considerably outperformed the S&P Small Ordinaries Index since 20101 as outlined below.

 

Performance since incepton of MVS's index


chart


Source: VanEck, Morningstar, as at 31 January 2017. Results are calculated to the last business day of the month and assume immediate reinvestment of all dividends and exclude costs associated with investing in MVS. You cannot invest directly in an index. Past performance of MVS' index is not a reliable indicator of future performance of MVS.

 

Active management plays an important role in the investing ecosystem. A lot of stock pickers have a strong track record in outperforming. However, the introduction of smart-beta strategies has given investors the opportunity to combine the best of both worlds.

1 Most active managers use the S&P/ASX Small Ordinaries Index as their benchmark

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Arian Neiron is the managing director of VanEck Australia. VanEck is a leading global provider of exchange traded funds (ETFs). This is a financial news article to be used for non-commercial purposes and is not intended to provide personal financial advice to any person.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.