Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 159

Opportunity knocks in global small caps

There are compelling reasons for Australian investors to make a modest allocation to global small capitalisation (cap) equities as a complement to large caps in a diversified portfolio.

As the aggregate pool of assets in Australian superannuation grows through mandatory contributions, investors have to consider moving greater exposure outside Australia. This has been led mostly through global large cap or global all cap investment strategies. However, a dedicated allocation to global small caps is an opportunity due to persistent excess returns evident over the last 10 to 15 years.

The size of the global small cap universe depends on the range of definitions reflected in the cut-offs used for maximum company size in various listed market indices. These range from US$2 billion up to US$5 billion.

For developed countries, a commonly-used index is the MSCI World Small Cap Index ex Aus (‘MSCI WSC’) which at A$6.4 trillion represents about 13% of the total listed global equities market of A$49.3 trillion. For MSCI WSC, there are currently 4,191 stocks in the index which indicates the vast number of possible investments.

The complementary developed countries large cap index is the MSCI World Large Cap Index (‘MSCI WLC’) which accounts for 84% of the total universe. In this index, there are currently only 1,581 stocks listed.

Global small caps add diversity

It is useful to compare sector and regional weightings to show how global small caps add diversity to investor portfolios:

  • Global small caps (MSCI WSC) currently have proportionally larger weights in industrials, financials, materials and consumer discretionary. The large caps (MSCI WLC) have major weights in consumer staples, energy, healthcare and telecom services.
  • MSCI WSC, compared to large caps, currently have proportionally larger weight in Japan and Pacific ex Japan and less in the US and Europe.
  • Comparing MSCI WSC with the sector weightings in Australia’s small ordinaries index shows Australia proportionally has over-weightings in materials, consumer discretionary and to a lesser extent telecoms.

Over the last 15 years, compared to other to other asset classes (in AUD terms), global small caps have been less volatile and generated better returns than Australian small caps and global emerging markets equities (in particular). As shown below, over time, global small caps have outperformed global large caps, particularly as the global equities bull market commenced after the global financial crisis in March 2009. However, there was a period of significant underperformance during the tech boom period of 1999-2000.

The graph also shows the currency impact for global small caps (includes both AUD and USD terms).? The fall in the Australian dollar over the last few years significantly boosted USD returns which was the reverse of the 1998-2002 period.

As would be expected, global small-caps tend to be less liquid and more peripheral in investor portfolios (that is, have a higher ‘beta’) and are more volatile in both up and down markets. Australian small caps (the orange line on the chart) have a different volatility pattern, reflecting the boom-bust commodity cycle.

Allocations to small caps

Based on assumptions and modeling work, we estimated a range of efficient portfolios allowing the strategic weightings to global and Australian small caps to maximise at 5%. The chart below shows the combination of optimal portfolios for expected return with the asset class weighting on the left axis. Asset classes are shown in various colours.

The illustration below shows that for virtually all expected return projections, it is warranted to hold a 5% weighting in global small caps (shown in pink). Australian small caps (shown in red) start to appear in the model simulation around 6% and grow to the 5% maximum at 7% expected return. If account is made for Australian dividend imputation then the optimal weighting would be lower, say at 3%.


Click to enlarge

Case for active management

As the MSCI WSC index currently includes 4,191 stocks, it is not highly concentrated, and active fund managers can construct well-diversified portfolios with high active share.

Analysis of global small cap manager returns (using a large USD data set) shows that managers that are in the 25th percentile and above (according to eVestment data covering the last 10 years to 31/12/2015) are consistently able to generate alpha (excess returns) of around 3% plus which is well above the median. The last three years have been particularly good for active fund managers with the higher performers generating excess returns between 3% and 9%.

There is a wide dispersion in manager returns over all time periods. This supports the view that managers need to actively manage their risks across a range of dimensions, particularly liquidity, unintended sector and macro positions, stock quality and currency.

Overall, there are sound reasons, supported by comparative market, asset class optimisation and manager return analysis, to maintain a significant strategic weighting in global small caps - up to 5% - in a well-diversified Australian balanced portfolio.

 

Nigel Douglas is Chief Executive Officer of Douglas Funds Consulting Pty Ltd, drawing on statistical analysis by asset allocation specialist research firm Heuristic Investment Systems and Eaton Vance Management (International) (EVMI). This article is general information and does not address the circumstances of any individual.

 

RELATED ARTICLES

Four ways to determine your international equities allocation

The problem with concentrated funds

Small caps v large caps: Don’t be penny wise but pound foolish

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Property

Coalition's super for housing plan is better than it looks

Housing affordability is shaping up as a major topic as we head toward the next federal election. The Coalition's proposal to allow home buyers to dip into their superannuation has merit, though misses one key feature.

Planning

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Retirement

More people want to delay retirement and continue working

A new survey suggests that most people aged 50 or over don't intend to stop work completely when they reach retirement age. And a significant proportion of those who delay retirement do so for non-financial reasons.

Economy

US debt, the weak AUD and the role of super funds

The more the US needs capital and funding, the higher its currency goes. For Australia, this has become a significant problem as the US draws our capital to sustain its growth, putting pressure on our economy and the Aussie dollar.

Investment strategies

America eats the world

As the S&P 500 rips to new highs, the US now accounts for a staggering two-thirds of the world equity index. This looks at how America came to dwarf other markets, and what could change to slow or halt its momentum.

Gold

What's next for gold?

Despite a recent pullback, gold has been one of the best performing assets this year. What are the key factors behind the rise and what's needed for the bull market in the yellow metal to continue?

Taxation

Consulting on the side? Don't fall into these tax traps

Consultants must be aware of the risks of Personal Service Income rules applying to their income. Especially if they want to split their income or work through a company.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.