(pictured Aidan Farrell with – from top left – Nigel Douglas, Fraser Murray, Richard Cahill, Clare Armstrong, Tim Hughes, Dennis Sams)
By Greg Bright
There are some unusual characteristics about global small caps. They outperform large caps over most periods, as you’d expect, and they have slightly higher volatility, as you’d expect. But they are also very different from our Australian small cap universe. So what does that mean for a big super fund’s portfolio?
According to a group of super fund investors and advisors at two roundtables last week, global small caps are worth a closer look. And Australia is a prime candidate for this scrutiny. Global small caps have some distinctive characteristics as an asset class, or sub class, but whether or not a fund manager can exploit those characteristics depends on a range of skills and resources.
Nigel Douglas and some others at the investor roundtables said that there was a compelling case for global small caps (developed markets ex-Australia) in a diversified portfolio.
The principal of Douglas Funds Consulting has recently been working with Melbourne-based Heuristic Investment Systems on a paper on global small caps which is expected to be released within the next month or so, co-published with Eaton Vance Investment Managers.
He said last week: “For Australian-based investors there’s a very strong case for investing from both a top down and bottom-up perspective… We came up with an optimal weighting in a typical balanced portfolio of up to 5 per cent… They provide significant diversity within a global equities allocation.”
Douglas studied 15 years of data for developed markets and on a risk-adjusted basis (Sharpe ratio) global small caps (in Australian dollar terms) were ranked second of the major equities asset classes for Australian investors for that period – after Australian large caps. Volatility was just under 15 per cent, which is lower than Australian small caps by a significant margin, Douglas said.
“And Australian small caps are only about 0.4 per cent of the developed global equities sector so there’s a very good case for diversification outside Australia, particularly when industry sector biases are considered.”
The nature of smaller companies is that they tend to be more “growthy” – more dynamic and faster growing. It should be pointed out that here, too, there’s a big difference between Australian small caps and global small caps. The median market cap for stocks in the global index is about US$1 billion, with the largest company in that MSCI developed global small cap index having a market cap of US$ 7.4 billion which is a large cap by our standards.
Manager dispersion in performance is quite wide in both local and global small caps. For global, Douglas found the top quartile of managers beat the index by around 3 per cent (gross of fees) consistently. Managers have to be good at managing the risks, such as unintended sector biases, uneven stock quality and liquidity.
In fact, it’s the manager skill which Fraser Murray, senior consultant at Frontier Advisors, says offers the main attraction from global small caps. He said that outperformance over time was small – about 0.8 per cent a year over the past 20 years for “broadly similar” volatility to global large caps. The volatility of global small caps is only slightly higher than that for large caps. If a manager can create some alpha with global small caps, it is worthwhile investing, he said. It’s a manager-specific decision.
During a presentation to his firm’s annual client conference in 2013, Murray said that there might come a time, soon, when most big super funds were unable to invest in Australian small caps because of size and liquidity. He said last week, though, that when Frontier clients were considering this dilemma, they did not automatically think of global small caps as the first alternative to replace their Australian portfolios.
The two Mercer people at the roundtables, Richard Cahill in Sydney and Clare Armstrong in Melbourne, voiced their firm’s positive view of global small caps. Cahill agreed with Douglas’s figures and said there was a case for having a dedicated global small cap mandate. Armstrong said: “We support global small caps in diversified portfolios, but investors need to believe in the value of fundamental research and active management. There are far fewer global small-cap managers than regional ones. In our [Mercer] universe there may be 100 US small-cap managers but far fewer global small cap managers.”
In fact, the Mercer survey (Global Investment Manager Database) has only 10 global small cap managers listed. Armstrong said after the roundtable that this low figure was misleading, though. “There are around 200 strategies in the database for global small caps, offered by 95 managers. Pengana and Real Index are Australian based. Fifteen of these strategies attract Mercer’s highest rating,” she said.
Tim Hughes, investment industry investor and current advisor to HESTA, said: “everything is fine, except for the volatility… The beta is volatile and sometimes the alpha is volatile… Looking through the volatility over several years is a challenge.”
But another advantage of global small caps is that compared with ‘All Caps’ or large caps indices, the small cap managers do not have to hold any particular stock, Hughes said. There are 4,300 stocks in the MSCI global small caps index, so any one stock is not going to make much difference compared with the index in a typical portfolio of, say, 120 stocks.
Aidan Farrell, the London-based lead portfolio manager for Eaton Vance’s global small-cap strategy, which was launched in Australia this month, said that there was consistent outperformance by global small caps versus the All-Cap index over a long period.
Farrell said that Eaton Vance screened the 4,300 stocks first to narrow down the universe and “break it down into bite-sized chunks”. The firm was well resourced for its fundamental research, he said, with three analysts in London, one in Tokyo and one in Boston and with the access to the work of five other analysts in Boston dedicated to US small caps. The firm’s modeling indicates that the new strategy will have a capacity of about US$3.5 billion. “But the trick is not to confuse market capitalization with liquidity,” Farrell said. “Liquidity is what concerns us the most.” Consequently, Eaton Vance’s portfolio has a median stock market cap of US$2-3 billion.
Three of its current investment themes are: concern about the Chinese economy making a transition from manufacturing; the electronic payments revolution and, as an example of one of the new-style Chinese service companies, a Chinese tutoring company which has been very successful appealing to the growing and aspirational Chinese middle class.
The investor roundtables in Sydney and Melbourne last week dissected the subject of investing in global small caps. Present in Sydney were: Richard Cahill, Mercer; Richard Dinham, State Plus; Chris Tse, Sunsuper; Ben Trollip, Willis Towers Watson; Turab Bank, REST Super; Andrew Howlett, Colonial First State; Tim Hughes, advisor to HESTA; Nigel Douglas, Douglas Funds Consulting; Duncan Hodnett, Eaton Vance; Louise Bradshaw, Eaton Vance; Aidan Farrell, Eaton Vance; Greg Bright, moderator, Investor Strategy News.
Present in Melbourne were: Clare Armstrong, Mercer Investments; Fraser Murray, Frontier Advisors; Stephen Jackman, PwC Consulting; Dan Hunt, ESSSuper; Shailesh Jain, Lonsec; Dennis Sams, investment committee member and former fund CIO; Duncan Hodnett, Eaton Vance; Aidan Farrell, Eaton Vance; Greg Bright, Investor Strategy News.