Welcome to my column, Young & Invested where I discuss personal finance and investing for Gen Z and Millennials.

This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.

Edition 18

Unironically, one of my favourite movies of all time is The Wolf of Wall Street – something that is always bound to elicit eyerolls.

If not for Leo DiCaprio’s acting prowess or voyeuristic indulgence in exorbitant displays of wealth, I think it teaches us a lot about how flawed human behaviour can influence how we invest.

When writing this week’s article, I thought back to the scene where Jordan Belfort makes his first sale at a boiler-room broker, after losing his job following Black Monday – the largest one-day market drop in history after The Wall Street Crash.

Belfort gets on the phone and picks an unsuspecting victim to sell stocks in Aerotyne International - “a cutting edge high-tech firm out of the Midwest awaiting imminent patent approval on the next generation of radar detectors that have both huge military and civilian applications now.” The scene then pans to Aerotyne’s high-tech headquarters – a small shed in a Midwestern backyard.

The wolf of wall street.
Aerotyne International Wolf of Wall St

Belfort drives his pitch home by insisting “Right now, John, the stock trades over-the-counter at 10 cents a share. And by the way, John, our analysts indicate it could go a heck of a lot higher than that. Your profit on a mere $6,000 investment would be upwards of $60,000!”

Now what Belfort was doing was pushing terrible penny stocks onto rather unassuming people, promising the allure of easy 10x returns. One of the reasons he was so successful in doing so, is his ability to take advantage of people’s desire for quick wealth.

I’m not likening calculated small cap investing to gambling, however, recounting my days as a beginner investor, the lines often blurred. I think this scene reflects how a lot of younger investors can be swayed by narratives surrounding small gap growth premiums.

I recently wrote an article on the beginner ETF portfolio, which suggested seeking low-cost, broadly diversified exposure to both domestic and international equity through 2-3 ETFs, without the typical inclusion of fixed interest.

Most funds under this approach provide negligible exposure to small caps – an asset class that has historically outperformed its larger counterparts. However, in the last few decades this hasn’t been the case. This week I’ll be exploring whether beginners should consider small cap exposure.

Before you go further into this article, I recommend reading should you invest in small caps.

Why do we care about small companies?

Smaller companies are generally in their infancy, tend to be more illiquid and volatile than larger peers, as well as steeped with higher uncertainty surrounding their prospects.

So why do we still talk about them?

To try and rationalise why some stocks have higher returns than others, scholars Eugene Fama and Kenneth French developed what we now call the Fama French or 3-factor model in the 1990s. In this, they expanded upon existing research to conclude that on top of market risk, a company’s size and valuation were also key factors that drove returns.

At the time, their data set found a return premium for owning smaller stocks relative to large stocks, as well as those with cheaper valuations. This evidence was quite clear for the decades leading up to the 1992 paper, however has been called into question after a few decades of small cap underperformance.

The model has been revisited frequently by other academics and even Fama and French themselves have since revised it to a 5-factor model. Whilst they weren’t the first to point towards small cap outperformance, they were the first to refine an understanding of this effect and therefore are largely credited with the assertion.

Why are they underperforming?

It’s no secret that over the last 20 years, small caps have been underperforming, contrary to academic belief.

Small caps trail the market globally

Assumptions of long-term outperformance meant that historically small caps traded at a premium to their large cap peers. This has since disappeared, leaving many to question whether investors believe the associated ‘size premium’ is dead – something that J.P. Morgan thinks may be true for cyclical and structural reasons.

Small caps are naturally more geared to the economic cycle and generally have more financial leverage than larger firms. This has made them more vulnerable to the Covid-induced slew of rate rises which have been the largest in several decades.

However historically speaking, the United States (a proxy for the global market) has experienced a generally lower interest rate environment since the early 2000s, which may have led to the proliferation of private equity and venture capital interest in quality small companies.

This results in an increased number of businesses deciding to stay private, postpone public listing or being taken private. Therefore, negative selection bias has been introduced into small cap indices, which have measurably declined in quality. For example, before the GFC, unprofitable firms were on average 27% of the Russell 2000. Now this number is closer to 40%.

Furthermore, the number of publicly traded U.S. stocks has declined by nearly 50% since the mid-1990s, dropping from approximately 8,000 to around 4,600. This trend can be attributed to several factors, with the most significant being a decline in IPOs and a rise in mergers and acquisitions.

Despite this, we do not believe it is all gloom and doom for small caps with pockets of value to be found. Director of Manager Research, Eva Cook recently explored why she believes small caps could shine bright in 2025.

How to invest in small caps as a beginner

The two ways you can invest in small caps are through the purchasing of individual stocks or by buying into a fund with exposure.

Small caps intuitively offer a higher growth runway, however, are also prone to significant risks, especially during economic downturns. I have previously discussed why I don’t invest in individual shares anymore and instead choose passive, low-cost ETFs – and I’d take a similar approach with small cap exposure in a beginner portfolio.

Beginners should be wary of the enticing but often misleading narratives that can surround lesser-known companies –reminiscent of the Jordan Belfort style salesmanship. Holding such positions require a long-term mindset and considerable due diligence – not an undying conviction that a speculative tech company will 20x in a year.

A beginner’s ability to consistently pick successful stocks is low and this becomes even more challenging in the small cap space where information can be scarce.

Morningstar’s Active/Passive Barometer is a study that examines the categories where active managers either add value or are outperformed by their passive counterparts. Active managers have an edge in narrower markets with limited information e.g. Australian small caps. On the other hand, this edge can be weakened when looking at broader markets e.g. a global small cap portfolio where passive funds tend to outperform.

Our top-rated small cap ETFS

If you have conviction in broad small cap outperformance overtime and have the risk tolerance, a good way to diversify away single stock risk is through an ETF that holds a basket of small caps.

When screening for Gold-Medalist small cap ETFs, Dimensional Global Small Company Active ETF (ASX:DGSM) and Perpetual ESG Australian Share Active ETF (ASX:GIVE) are our top active picks, meanwhile Vanguard MSCI International Small Companies Index ETF (ASX:VISM) is our top passive choice.

It is important to check the composition of your existing holdings, which may already have an allocation to small caps. For example, Vanguard Australian Shares ETF (ASX:VAS), has a ~6% allocation to small and micro caps which may be adequate exposure for some.

There are also several distinguishing factors between Australian and US small caps that you can read about here.

Read previous Young & Invested columns

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