Investing in global small caps makes sense from a diversification and return point of view, if you can stomach the volatility
According to Doug McGraw, a global equities fund manager at Invesco Perpetual, there has been a resurgence of interest in global diverse equity-seeking strategies from pension funds over the last 4 to 5 years.
This makes, sense, and if some equity managers are to be believed, is a virtual necessity for funds in search of alpha. According to Invesco, global smaller companies tend to outperform larger companies in periods of economic recovery, so history lessons have played their part in getting trustees to look at the smaller and more dynamic part of the global economy.
But it's not just the returns that can be healthy. Small Caps form the bottom 15% of the market capitalisation of the global stock markets, up to about $3.3bn. A study by Brown University in Rhode Island, which looked at the US equity market from 1926 to 2007, says that smaller companies offer unique diversification benefits compared to other asset classes such as short-dated and long-dated bonds – something every pension fund invests in.
The study shows that over the longer term the return from these higher risk assets outstrips the level of risk. So in the long-run it improves the risk-return trade-off.
However when it comes to global small cap investing, only a small minority of pension schemes are currently involved, and that's not always on an international basis either. In the UK, for example, cautious trustee boards tend to mainly invest in small caps through the domestic equity market.
No borders
McGraw's colleague at Invesco, Nick Hamilton, head of global equity products, says that this reluctance to look beyond borders could be an unnecessary precaution, and one that leaves schemes missing out.
"Mandated asset allocations per region are just too limited nowadays," he says. "We should start to think about global as its own asset class, and not get constrained by borders but look at good investments."
Andrew Cain, CEO at investment firm Dimensional, says that Hamilton's wish may be closer to becoming reality than he may think. He claims to have started to see more investors who think of the global market as one entity.
"If you look back some 20 years you see there was only a negligible investment in smaller companies and any investment tended to be made in the domestic market. Then what we saw was a kind of tentative explorative investment in non-domestic small cap. But they were more opportunistic investments, without a definite approach," he says.
Ian Shea, a senior associate at consultancy bfinance, says that he too can track a slow growing demand in global small caps.
"We have conducted a large number of international equity small cap mandates but very few global ones. However, we have recently had a few clients asking about the potential universe," says Shea. "I would say this is because it is an under covered asset class, currently, that has seen significant performance returns over time.
"With the increasing allocation to global equity mandates by institutional investors it's likely having the impact of overweighting large cap companies in clients' overall portfolios and so some allocation to global small cap may make sense from a diversification perspective," he adds.
Cain also champions the diversification benefits of small caps, pointing out that there is a lower correlation between the movement of the return from a small company portfolio than the large company portfolio.
"Pension funds are pretty well diversified but they tend to be heavily weighted into large company investments," he says. Cain believes that shifting some of that towards smaller company investments, in a part of the market that doesn't move in the same way as the rest of their portfolio a lot of the time, makes perfect sense.
"Large caps are clearly important and will always be the predominant part, but the excess return of small cap can be pretty important to the equity return for an investor," he adds.
Then there is the negative correlation small caps have had with the bond markets over the last ten years. The same of which cannot be said for large caps.
"Pension schemes are very large holders of bonds, (and) smaller companies balance that exposure, given the high volatility of the asset class. It is a beautiful negative correlation with bond markets," he says.
The active route
Small caps grow faster than large caps simply because of their size, they are more capital efficient and Hamilton explains that if ownership increases so too does the performance of the business. Most small caps have a high involvement of management.
"If you look at smaller companies globally the average level ownership is many times higher than of larger companies," he says. "Studies say that if ownership increases so does the performance of the business. The alignment of interest is very powerful; the managers are often the founders or closely associated with it."
So what is the appropriate approach to invest in global small caps?
Hamilton says that there aren't a lot of global small cap fund managers out there. "It is incredibly labour intensive, research heavy and the universe is enormous. These factors are reasons for fund managers to shy away from global small cap investing. From an active perspective; there lies the opportunity to turn over the stones on these businesses and find the gems within."
An argument can be made for avoiding a passive strategy: it is an inefficient market, with the potential for large anomalies in company share prices. Added to that, research coverage of small caps is very light.
Volatile
As a group, smaller companies carry more risk then large companies, for various reasons. They have a high liquidity, high volatility and can be subject to company or sector specific issues. "Certainly when you invest in small companies you will have to go in with your eyes wide open," says Cain.
"You cannot be subjective to kneejerk reactions. If you do you will destroy value. Small companies can take a hard kick in situations like we see now in Japan or have seen here during the crisis, that's why you have to be in it for the long-term.
According to Cain, trading smaller companies requires discipline and a longer-term focus.
Hamilton agrees: "In times of crises, volatility spikes. These companies are more liquid and sometimes the movement of the share prices can be more extreme and we certainly saw instances of that in our Japanese portfolio."
"Some people will panic or will believe the worst case scenario, but Japan is a unique example because all the small and mid cap companies there that we own are very highly exposed to international trends or are suppliers to larger Japanese companies that are dominant," he says.
"You do get a lot more potentially economic sensitive exposure," says Hamilton. But you recover faster as well. As risk abates small caps do very well."
azeevalkink@wilmington.co.uk
First published 07.04.2011
