The demand for small-cap equity strategies has been noticeably stronger among our pension fund clients through the ongoing late phase of the market cycle.
The underlying motivations for seeking small-cap equities have evolved: rather than counting on a "size premium," investors are seeking to improve the diversification of their existing equity exposures and, in certain markets, take advantage of strong active manager performance. In doing so they are also grappling with a changing manager landscape, particularly the recent proliferation of global small-cap funds.
Few risk premiums have as illustrious — and controversial — a history as size. One of the three factors used in the Fama/French three-factor model alongside "value" and "market," it has been the subject of more academic papers than any other member of the factor family. Many of these were produced in the 1980s, beginning with Rolf Banz's seminal article in 1981. In the face of data that appeared to suggest that a size premium did exist, theories were propounded for why it should exist. These included the pricing inefficiencies that can result from limited analyst coverage, lower liquidity and the supposedly easier growth trajectory.
Yet the size premium has now been extensively unpicked. At first glance, before adjusting for risk or for the various style premiums, small-cap indexes have outperformed large-/midcap indexes since 2000 on both a global and a regional basis. Yet the size effect is statistically insignificant once the data has been adjusted for beta, and even more so when other now-popular analytical methods are applied such as style regressions. What remains is undermined by the greater illiquidity and higher trading costs involved.
That said, our analysis suggests that a statistically significant size premium resurfaces once indexes are regressed against the quality factor. We find that the addition of the quality factor not only raises the average return to size significantly but also increases the precision of the size premium.
Manager performance is key
Although it is important to examine the indexes, it is perhaps even more important to scrutinize the performance of small-cap managers when examining the case for investing in this sector. Alpha generation varies greatly depending on region. In Australia, for example, 100% of active small-cap managers in the eVestment database have outperformed the MSCI Australia Small Cap index over 10 years and the median performer generated average outperformance of 7.4 percentage points a year; although this data set has some problematic biases and survivorship effects, the figures are still compelling.
Investors should seek a clear understanding of the sources of such outperformance. In the case of Australia, these impressive figures have often been facilitated by macro-led or cyclical bets, such as the degree of exposure to commodity-related sectors through periods of stronger and weaker prices. Looking at various international markets, we find that a significant number of active small-cap managers have boosted relative returns by adding exposure to midcap stocks — an approach that some investors are more comfortable with than others.
Diversification in focus
Consistent long-term outperformance — whether it be for small-cap indexes relative to other indexes or for active managers relative to benchmarks — may still be a subject for debate. Yet pension fund and other investor allocators today have another priority: diversification.
Most sizable long-term investors tend to be structurally underinvested in small-cap stocks. This has been reinforced, and to some extent exacerbated, by two of the most notable equity investment trends of the past decade: the shift toward global mandates from regional and the shift toward passive management. Within actively managed global equity funds, we tend to find small-cap stocks either absent or representing a minimal slice of portfolios. For investors using passive global indexes, small-cap exposure will be absent unless the institution has specifically decided to include a small-cap index.
During the extended bull run (notwithstanding major fourth quarter 2018 and first quarter 2019 fluctuations), strong equity market returns have been somewhat too reliant on a relatively modest number of large-cap stocks. With this in mind, investors have sought to broaden the drivers of return within equity portfolios through geographical and strategic diversification.
When considering the diversifying characteristics that small-cap investment may offer relative to large-/midcap stocks, it is important to pay attention to the differences among different regions. Small caps in Japan, for example, are relatively insulated from the "tourism effect" exhibited by large-/midcaps in this market, wherein foreign investors flow strongly in and out at certain periods (such as when executing currency plays), due to the far lower involvement of international investors in the small-cap segment.
One source of performance differentiation between large-/midcap and small-cap indexes is the significant difference in sector exposures. While small-cap investors can benefit from the opportunity to access different types of business with different return drivers, we should be cognizant of the extent to which outperformance or underperformance may represent a sector bet in disguise.
Implementation choices and challenges
Investors complementing equity portfolios with small caps face a set of portfolio design choices. To some extent, these options mirror those available in large-/midcap equity investing: global vs. regional, active vs. passive, discretionary vs systematic. However, certain aspects of implementation can be more challenging on the small-cap side, and those issues (as with so many of the previous points) vary significantly by geography.
For example, passive management in small cap can be problematic and expensive: greater illiquidity, higher trading costs and the sheer volume of stocks being traded (about 4,200 in MSCI World Small Cap vs. 1,650 in MSCI World) create greater friction and leakage. Fees are on the high side in active management as well, although we find that U.S. active small cap is significantly more expensive (median 75 basis points) than other regions (median 60 basis points). When it comes to active management, we find that capacity constraints are significantly more problematic in small cap — particularly for certain regions — than in large-/midcap.
One particularly interesting trend in small-cap implementation is the proliferation of global small-cap funds and strategies. We estimate that there are now more than 70 such strategies available, three times higher than the figure 10 years ago. This trend has produced an increasingly credible universe of options for institutional investors to consider, although managers' track records are on average somewhat shorter than those in well-established regional small-cap markets.
Investors should keep an eye on alignment of interests. In many cases, the managers offering global small-cap strategies are also offering one or more local small-cap strategies covering at least one of the underlying markets. This combination of products can create challenges in terms of alignment, especially where that market may be capacity constrained. The investor should consider how decisions are being made for the global fund and the extent to which these represent an extension of local small-cap strategy team picks or sit independently.
It is worth noting that only 41% of global small-cap managers integrate environmental, social and governance criteria into investment decision-making. A similar number say that they do not, and a further 18% do not say either way in response to information requests in RFPs. To some extent, this lack of ESG consideration with global equity fund peers relates to the origins of these global small-cap strategies: many have roots in the U.S. small-cap sector, where the ESG theme has only recently begun to gain traction.
We expect strong interest in small cap to continue in 2019. Yet in answering key strategic questions — global vs. regional, active vs. passive — the best path should not be determined by theory, dogma or simple analysis of indexes. Instead, it should consider the practical attractiveness and appropriateness of strategies available in the market today.
Justin Preston is senior director and head of equity, public markets at bfinance, London. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.