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Think twice before investing in global small-cap funds

Emma Rapaport  |  06 Sep 2019Text size  Decrease  Increase  |  
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Morningstar analysts are advising investors to tread carefully when considering adding global small-cap funds to their portfolios, with active managers struggling to deliver returns above the benchmark.

Australia's global small-cap fund universe has grown considerably over the past 12 months, with several managers launching products in the local market.

Morningstar associate director, manager research, Michael Malseed says a marketing case for these products is clear.

First, he highlights evidence showing small companies outperform large companies over the long term.

"Small companies in aggregate are likely to display higher earnings growth (off a low base) given they are generally at an earlier stage of their business lifecycle compared with more-mature large companies," he says.

"Assuming they can survive through the cycle, they are likely to achieve greater share-price appreciation over time (albeit with significantly higher volatility)."

Second, Malseed says small companies are typically under researched, allowing for incorrect pricing at the smaller end of the market, which can be exploited by a skilled fundamental manager.

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"While the annual reports and accounts of mega-corporations are pored over by armies of analysts, many small caps are ignored," he says.

Domestic small-cap managers have performed

But while domestic small-cap managers have demonstrated their ability to beat the S&P/ASX Small Ordinaries benchmark (over a long period), Malseed says the same cannot be said for global small-cap strategies beating the MSCI World Small Cap benchmark. This is especially true for smaller teams investing across multiple countries, he says.

"The bottom line is small-cap investing is fraught with risks, and managing these risks becomes more difficult when dealing across multiple geographies and currencies.

"Small teams are likely to struggle to stay abreast of localised issues, increasing the risk of being caught by idiosyncratic shocks, and constraining the ability to outperform with a high degree of consistency."

Malseed says Aussie small-cap managers have outperformed the benchmark due to the index containing a large number of speculative and low-quality names such as mining explorers, which active managers can benefit from by simply not owning.

Morningstar's Australian Fund Equity Mid/Small Blend category has outperformed its benchmark over 82 per cent of rolling 3-year periods going back to 1993.

Seek out large teams spread across multiple geographies

Malseed's preference among global small-cap managers leans towards those with large global teams with multiple local presences, like silver-rated Lazard Global Small Companies, or systematic approaches that look to extract the small-cap premium while diversifying away stock-specific risks, such as silver-rated Dimensional Global Small Companies Trust.

Given the poor track record of active management in the space, Malseed says the passive index option of Vanguard International Small Companies is hard to beat.

"While the alpha opportunity in global small caps appears attractive, active managers have struggled to deliver," he says.

"We advise investors to exercise caution, especially when looking at small teams with limited track records."

is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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