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Small-cap managers face headwinds going global

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Specifying: Michael O’Brien sees more individual searches for global small caps.

Just as investors needed to diversify their equity portfolio overseas, they're now beginning to shed their home bias when it comes to small-cap equity strategies.

However for money managers, investing in smaller companies overseas comes with high hurdles in cost, liquidity and capacity constraints.

As clients worldwide globalize their equity portfolios, they're “typically not investing as much in small caps,” said Debbie Clarke, head of the global equities boutique at Mercer, London.

Even as investors diversify into emerging markets, they're usually investing in larger global companies within that sector.

To balance the tilt toward large-cap stocks, some investors have increased their exposure or are considering a separate allocation to global or international small-cap mandates, which often combine emerging and developed markets, said Nick Hamilton, head of global equity products at Invesco (IVZ) Perpetual, Henley-on-Thames, England. Global emerging markets small-cap strategies are also gaining traction, sources said.

Inflows are relatively modest, coming mostly from institutions in Europe, Australia and Canada, but some U.S. pension funds including the $1.8 billion Fort Worth (Texas) Employees' Retirement Fund are also making the move.

“The home-country bias has gone down radically for large-cap equities,” said Mark Thurston, head of global equity manager research at Russell Investments, Seattle. “While the trend for globalizing small-cap exposure is real and it is happening, it's still pretty small compared to all the dollars that's out there.”

Managers competing for inflows into global small-cap strategies include Dimensional Fund Advisors, Invesco Perpetual, Franklin Templeton (BEN) Investments (BEN), Pyramis Global Advisors, Aberdeen Asset Management PLC, Schroders PLC, Hermes Fund Managers Ltd. and Ashmore Group PLC.

“We're seeing global small-cap (equities) increasingly being pulled out as separate searches,” said Michael J. O'Brien, London-based managing director and global head of J.P. Morgan Asset Management (JPM)'s institutional client group.

“Running a small-cap portfolio on a global basis offers a broader opportunity set and some diversification benefits” compared to a global equity portfolio tilted toward large-cap stocks, said Andrew Kirton, London-based global chief investment officer at Mercer. “We would start from the premise that (investors) should have a long-term bias to small caps, depending on valuations.”

In addition, combining developed and emerging markets small-cap equities can be a more efficient way to implement the portfolio, said Stephen Clark, vice president and North American head of institutional at Dimensional Fund Advisors, based in Austin, Texas. Dimensional has $250 billion in total assets under management, including $50 billion in dedicated small-cap strategies. The firm takes a systematic approach to small-cap investing, which allows the firm to take advantage of liquidity constraints within the sector rather than be hampered by it, Mr. Clark added.

The MSCI World Small Cap index has outperformed the MSCI World index over the past three, five and 10 years on an annualized basis. In the 10 years ended Sept. 30, the MSCI World Small Cap returned 11.97% compared to 8.61% for the MSCI World during the same period, according to data from MSCI.

The correlation between the S&P 500 and the MSCI World ex-USA index is about 0.9 compared to 0.82 between the S&P 500 and the MSCI World ex-U.S. Small Cap index.

Risk premium

“Smaller companies tend to be at the less-efficient end of the market and are often less well researched,” Mr. Kirton said. “There is also an expected risk premium attached to small-cap investing. The combination of these (factors) should contribute to long-term returns, and historically, small caps have beaten the broader market.”

However, Mercer's Ms. Clarke added: “It's challenging to find a good global small-cap manager.”

At J.P. Morgan Asset Management (JPM), for example, executives had considered launching a global small-cap strategy, but capacity constraints in the firm's regional small-cap strategies meant holding off on such a move for now. “A global small-cap strategy is not simply a combination of regional mandates, and capacity constraints present a real challenge,” Mr. O'Brien said.

Unlike large-cap equities, fundamental active managers investing in small-cap stocks need extensive on-the-ground coverage, consultants and managers said. “It's definitely the most research-intensive (strategy) we run,” said Mr. Hamilton of Invesco (IVZ) Perpetual, which has about $1 billion in a dedicated global smidcap equity strategy.

Allianz Global Investors' global small-cap strategy is regionally neutral, said Andrew Neville, director and equities portfolio manager in the firm's smidcap team.

“The best example of why it's best to be regionally neutral is Europe, which has been thought of as a pretty poor place to invest,” Mr. Neville said. Yet European small caps are up by about 22% in U.S. dollar terms” so far this year. “If we had had a view on the region, we might have missed out” on the returns, he said. Allianz GI has $14 billion in AUM in all small-cap strategies.

Allianz Global Investors' global small-cap strategy outperformed the MSCI World Small Cap index over the one-year and three-year periods ended Aug. 31. However “small caps are more correlated with risk, so they tend to do worse when there's a sharp (economic) slowdown or a recession,” Mr. Neville added.

The short-term volatility during the 2008-2009 financial crisis is still keeping many investors at bay for now, sources said. However, “global small-cap equity products appear to be gaining some traction with institutional investors thus far in 2012 with $279.3 million in net inflows,” according to an e-mail from investment data provider eVestment Alliance. Net institutional inflows for Europe, Australasia and Far East small-cap products totalled $38.4 million during the same period.

Global emerging markets small-cap equity strategies attracted more than $1 billion in net inflows each year in 2010, 2011 and so far in 2012, according to eVestment Alliance.

Break with tradition

At Ashmore Group, investors' demand for overall emerging markets strategies is combined with a need for small-cap exposure within one global strategy, which was launched in 2011. “Within emerging markets, investors are diversifying away from traditional core active or core index.” said Julie Dickson, a London-based product manager for equities at Ashmore EMM LLC, the specialist emerging and frontier markets equities manager that's part of Ashmore Group. Ashmore EMM has about $7 billion in AUM, of which about $700 million is invested in a dedicated global emerging markets small-cap equities strategy.

Aberdeen AM's global small-cap strategy, which has outperformed the MSCI All Country World Small-Cap index over the past one and three years, combines both developed and emerging markets. The strategy is fairly concentrated with 40 to 60 stocks, about 30% of which are listed in emerging markets, said Andrew McMenigall, senior investment manager on the global equity team at Aberdeen AM, which manages about $7 billion in small-cap equities.

“There's not a huge turnover in the portfolio,” said Mr. McMenigall, who is based in Edinburgh. “We really do want to take a long-term view.”

Data Editor Timothy Pollard contributed to this article.

This article originally appeared in the October 15, 2012 print issue as, "Small-cap managers face headwinds going global".