Gill Wadsworth writes that in a world where returns are hard to come by, it might be reasonable to assume that institutional investors would be clamouring to include a sector that has delivered returns in excess of 10 per cent over the past three years.
This is precisely what the MSCI All World Small Cap index has done, outperforming its large cap counterparts by 53 basis points in the three-year period to 11 May 2023, returning 10.53 per cent.
According to research from consultant Bfinance, the appeal of small cap equities becomes even more compelling when looking at active manager performance which reveals that “a majority of global small cap managers have outperformed the MSCI ACWI Small Cap since 2009 on a rolling three-year basis, even when we account for an indicative 75bps management fee”.
Yet Robert Doyle, Senior Director within Bfinance’s Public Markets team specialising in equity manager research, says relatively few institutional investors and asset owners have distinct allocations to small caps, with investment consultants favouring the “easier solution” of gaining exposure to the universe via ‘all cap’ equity strategies.
“It is extremely rare to find a dedicated small cap manager [in institutional portfolios]. The trend to passive global equity strategies has squeezed out niche and regional strategies,” he says.
Morningstar reports that in the 12 months to 30 June 2022, passive mutual funds and ETFs reported estimated net inflows totalling USD744.28 billion, while active funds reported estimated net outflows totalling USD373.40 billion over the same period.
Doyle adds that small cap stocks suffer from a perception that they are both riskier and more volatile than their larger cap counterparts.
But the Bfinance research finds that adding small cap exposure does not necessarily increase overall portfolio volatility.
Doyle says: “Modelling does continue to support the case that active small cap improves portfolio diversification and can boost returns, albeit with increased risk as measured by volatility. We believe small cap is best used as a satellite or alpha generator rather than a core position.”
However, Doyle concedes that success in small cap investment is dependent on finding the right active manager; a task that is not straightforward.
The global small cap active manager universe exhibits an “impressive degree of outperformance”, with more than half of managers generating positive excess returns net of fees over three-year rolling periods, Doyle says, but finding those managers is “easier said than done”.
“Conducting manager research in the small cap equity space can be somewhat challenging for a variety of reasons, chief of which is the high turnover in the universe of managers that have appropriate capacity for receiving new capital inflows,” he says.
Doyle says it takes time and resource to find the managers with the best in-depth teams capable of researching the vast small cap universe.
Doyle says consultants may view this sector “as an inefficient use of their resources, given the amount of research required to recommend a strategy, and may have an internal preference for obtaining small cap exposure through all-cap strategies – if at all”.
Yet Doyle says he has seen an increase in interest from institutional investors to allocate to specific small cap mandates.
“The last three to four months [small caps] have become a much more common topical conversation with institutional investors. Maybe they are little slower in terms of doing it, but they are looking at small caps, thinking about them and understanding what role they could play in the portfolio.”
