bfinance report: ‘Small Cap: Old Questions, New Answers’

5 feb 2019

NOTABLE INTEREST OVER PAST YEAR FOR SMALL CAP EQUITY STRATEGIES FROM ASSET OWNERS LOOKING TO COMPLEMENT AND DIVERSIFY EQUITY EXPOSURES

“Global small cap strategies” have undergone significant expansion in the past decade with the number of active funds available trebling, offering an alternative to traditional regional strategies

Characteristics of small cap markets vary greatly from region to region, as does the performance of active small cap managers.

Pension funds remain structurally under-exposed to small cap equities – a dynamic that has been reinforced by key trends such as the shift to passive management.

Key conclusions of latest bfinance white paper: ‘Small Cap: Old Questions, New Answers’

bfinance white paper: ‘Small Cap: Old Questions, New Answers’ concludes that the past year has seen a notable greater interest from pension funds and other asset owners in small cap equity strategies whether regional or global. The motivations for seeking small caps are evolving, with allocators looking to diversify their existing exposures rather than chasing a “size premium.”

Shift to passive and from regional to global equities has reinforced under-exposure to small cap equities

Looking globally, pension funds and other asset owners are structurally under-allocated to small cap equities. This lack of exposure has been reinforced by two key trends of the past decade: the move from regional to global equity strategies and the shift towards passive investment. Within actively managed global equity funds, small cap stocks have either been absent or represent a minimal slice of portfolios. For investors using passive global broad market indices, small cap exposure will be largely absent unless the institution has specifically decided to implement an investment in a small cap strategy or index. Where investors do have additional small cap exposure, it is frequently confined to the domestic market, particularly for institutions in the US and Australia.

During the recent extended bull run, strong equity market returns have been somewhat reliant on a relatively modest number of large cap stocks. With this in mind, investors have sought to broaden the drivers of return within equity portfolios through geographical and strategic diversification. This priority is helping to drive and shape demand for small cap.

Investors should scrutinise regional differences, sector exposures, drivers of active manager performance

It is important to pay attention to the differences between various international small cap markets. In Japan, for example, many small caps are relatively insulated from the “tourism effect” exhibited by large mid-caps in this market, wherein foreign investors flow strongly in and out at certain periods due to far lower involvement of international investors in the small cap segment.

One source of performance differentiation between large / mid cap and small cap indices is the significant difference in sector exposures. While small cap investors can benefit from the opportunity to access different types of business with different return drivers, we should be cognisant of the extent to which outperformance or underperformance may represent a sector bet in disguise.

The characteristics of small cap investment, both on a standalone basis and in comparison with the relevant large/midcap market, vary significantly by geography. There are also considerable differences between the performance and risk profile that will be delivered by an actively managed strategy versus the relevant small cap index, and these differences also vary by region.

When forming strategic decisions regarding small cap equity exposure, investors should pay attention to active manager performance and exposures. While analysis of indices (small cap versus mid/large cap) can help investors to form a view on the sector, the small cap manager universe offers a very different picture in terms of returns, volatility and exposures to various sectors and styles. Again, these differences vary considerably by region.

Implementation choices and challenges

For investors wishing to invest in small cap globally there are two main options: combining regional strategies or investing in a “global small cap” strategy. While both approaches have received attention recently, active “global small cap” funds have gone a particularly significant expansion, with the number of active funds available to institutional investors trebling to more than 70 in the past decade. The trend has produced an increasingly credible universe of options for institutional investors to consider, although managers’ track records are on average somewhat shorter than those in well-established regional small cap markets.

In many cases, the managers offering global small cap strategies are also offering one or more local small cap strategies covering at least one of the underlying markets. This can create challenges in terms of alignment, especially where that market may be capacity constrained. The investor should consider how decisions are being made for the global fund and the extent to which these represent an extension of local small cap strategy team picks or sit independently.

Justin Preston, Senior Director, Head of Equity, Public Markets at bfinance said: “Investors looking to increase their exposure to small cap equities should carefully consider whether global or regional approaches to small cap represent the optimal approach for their portfolios. In doing so, it is important to remember that the best path may be determined not purely by theory or examination of the indices but by the appropriateness and attractiveness of solutions available in the market today. Investors complementing equity portfolios with small cap exposure face a set of portfolio design choices. To some extent, these mirror those available in mid/large cap equity investing, including global vs regional, active vs passive, discretionary vs systematic. However certain aspects of implementation can be more challenging on the small cap side, and those issues vary significantly by geography. As is so often the case, it is helpful to understand pragmatic considerations for implementation before formulating strategic decisions.”