Small caps: global questions, local answers?

Written By: Justin Preston Senior Director, Head of Equity, Public Markets Research bfinance

Justin Preston of bfinance examines the popularity of small cap equity and strongly advises paying attention to local and regional issues when selecting a global small cap investment strategy

Small cap equity, whether through local or global strategies, has been a particularly popular destination for recent investment by pension funds and others. Yet investors should pay close attention to regional nuances, both when examining the arguments for adding small cap exposure to the portfolio and when assessing managers or strategies for implementation.

Strong demand for small cap can be viewed as one facet of a broader trend: the need to improve equity portfolio diversification, with many market participants now expressing concerns over the relatively small group of stocks driving equity performance. Such concerns have also, incidentally, helped to bolster appetite for emerging market equities through the later stage of the cycle.

This diversification agenda has proven more influential than the relative valuations of small cap stocks, although these were particularly attractive on a relative basis for part of 2017. It has also proven to be largely separate from investor beliefs about the size premium, where the evidence supporting passive outperformance of small cap stocks has become somewhat weaker over recent decades.

In many ways, small cap proves to be a logical candidate for differentiated equity exposure. On the whole, pension funds and other asset owners tend to be under-exposed to this segment globally. The exception tends to be the domestic market, especially when the investor is located in a region with a strong small cap tradition such as the US or Australia.

This under-exposure has, to some extent, been reinforced or exaggerated by the increasing popularity of global equity strategies at the expense of regional equity strategies. With some notable exceptions, the majority of active global equity strategies do not give meaningful coverage of the small cap universe across the relevant markets.

Active managers with a more quantitatively-driven process can be further inhibited by data shortages due to relatively low levels of analyst coverage per stock, although this point is less relevant in the US than elsewhere. Those with a more fundamentally-driven process can be limited by the ability to get boots on the ground in a meaningful way. Global equity strategies with large volumes of assets under management are inherently less well-suited to small cap; those with small volumes are less likely to have substantial teams across relevant locations.

As a result, we have increasingly seen investors looking at small cap offerings both within and beyond their home markets. This can involve tapping into regional managers in one or more destinations, or it can involve implementation through a global small cap product – an increasingly popular and credible approach, serviced by a growing number of managers. In some ways, the global route is the natural complement to an existing global equity strategy.

Yet, while the appetite for small cap has been strong, investors should pay close attention to the differences in small cap in various regional markets. An investor familiar with the local small cap market – its sector exposures, its diversification characteristics relative to mid and large cap stocks, its managers, the ease or difficulty with which portfolio managers beat either small cap or non-small-cap local benchmarks, its costs – will find that the same lessons do not apply across borders.

For example, the US small cap sector has generally been seen as a way of gaining exposure to fast-growing technology and healthcare firms, although this characteristic has been under pressure recently due to the significant decline in new listings – a side effect of strong investor demand in private equity markets which has pushed up unlisted company valuations. We don’t see that same strong orientation towards tech in the small cap markets of Australia and Japan, where instead sectors such as retail are more prominent.

In Australia, small cap managers have generally outperformed the overall market – a pattern which is certainly not a feature of small cap across international markets. As a result, small cap investment is more strongly influenced by the prospective performance pick-up and less reliant on the diversification story. At the same time, these managers have also found it relatively easy to outperform the country’s two more popular small cap indices during recent years, largely through reducing exposure to commodity stocks at a time of weakened prices.

In Japan, the lack of data for small cap stocks poses a much more evident challenge than is the case in either US or Australia, creating greater scope for inefficiencies and making a highly quantitative approach less realistic than it would be in the US market. In addition, the Japanese small cap market is relatively resistant to international capital flows in comparison with the country’s mid and large cap markets. For the former, we see a high proportion of committed (non-tactical) domestic retail investors, and evident language barriers for non-Japanese participants. For the latter, there is a substantial degree of “investment tourism” at play, translating into capital flight at moments of stress. This creates some very interesting performance dynamics, with small caps exhibiting an unusual degree of robustness relative to mid and large cap stocks.

Such local nuances can evidently affect whether, when and how regional small cap investment would make sense for particular asset owners. An investor that has opted not to pursue small cap in the US, for example, will find a different set of arguments for and against small cap in Australia.

Yet these local issues can and should also colour an investor’s approach to selecting a global small cap strategy – an increasingly viable and well-supplied route. When selecting a manager covering a range of regions, it is important that the strategy is still founded on appropriate local expertise. Small cap is not something that is easily done well from a distance, especially in markets where data is less widely available and less rich.