Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 248

A better way to measure Australian small caps

In a quest to diversify portfolios from the concentration biases found in the large cap Australian equities market, investors often allocate a defined (and usually static) weight to Australian small cap investments. This intuitively makes sense, because we expect to achieve superior diversification by investing outside the large cap stocks, and because of the belief smaller companies will have stronger earnings growth opportunities.

But these views may be flawed.

The small cap index is a dud index

Over the long term, the small cap index has underperformed the large cap index by around 2.8% p.a. (since 1990) and has done so with 25% higher risk. That’s not to say there are not significant opportunities in small caps from time to time, with the performance differentials between small and large cap significant over the short term. Actively managing the rotation in and out of the small cap market should be a consideration, and timing is important.

Source: Schroders, Global Financial Data. Returns from 1 Jan 1990 for S&P/ASX Small Ords and S&P/ASX 200 (All Ords before 1/4/2000).

The index construction that provides risks and opportunities

In Australia, the lack of a mature venture capital industry results in listing rules that do not consider a business’s profitability or financial viability, unlike in other global markets. There are times where our market is built around a large number of no-revenue or no-profit generating mining companies. For small cap equity managers, when one of the most effective portfolio construction methods is to avoid the losers, is it reasonable to pay an active or performance fee based on this market anomaly?

Our belief is that while the average active manager in Australian small caps has been able to outperform the index, this is due in a large part to the inefficiencies in the index construction. On average, small cap managers earn a fee 60% higher than that for large cap portfolios. While at a base fee level there is some justification for this given the relative size of assets that can be managed in each market cap segment, we would suggest investors should be wary of the potential for large performance fees to be accrued versus the poorly-constructed small cap index.

A broad-cap flexible approach should be adopted

Valuation is a strong indicator of future returns and this belief is supported by analysis of starting point Price to Earnings ratios (P/E) and the subsequent 3-year performance, as shown below.

There is a distinctive trend towards higher valuations in small caps leading to subsequent underperformance relative to large cap. Interestingly, higher valuations in large caps don’t necessarily lead to underperformance of small caps. At present, small cap P/Es are relatively high compared to history (at 18.7x) and higher than the large cap market.

It makes sense for investors to explicitly consider the valuation differences between small and large cap stocks in making their investment allocations. Not all investors have the skill and tools to either monitor the timing of asset allocations or the ability to change the investments. We believe the decision and implementation for actively managing Australian equities is best made by a broad-cap investment manager with skills to understand when the opportunity is right across the full market cap spectrum (large, mid, small and micro-cap sectors). This ensures stock specific ideas can be prioritised rather than esoteric ideas coming from a specific cut off point in a benchmark.

Source: Thomson Reuters Datastream, Global Financial Data, Schroders Analysis

Benchmarks and active management

An objective look at the opportunities presented across the small and large cap markets suggests that segmenting the allocation by market cap (as defined by some arbitrary stock number) isn’t necessarily the best way for investors to manage their portfolio. Investors may wish to consider a bias toward smaller caps to take account of the greater economic diversity from this part of the market. However, an alternative broad-cap exposure is a different way to structure a client’s aggregate equities exposure versus separate small and large cap portfolios.

We conclude that:

  • The small cap index is poorly constructed and suffers from significant structurally lower long-term performance, higher risk, and poorer earnings growth characteristics.
  • Active management of this part of any Australian equity exposure is both essential and rewarding.
  • The appropriate benchmark against which performance should be measured and fees calculated is a broader market index or the large cap index, rather than a specifically small cap index as this is more representative of the opportunity set and removes the bias created by an arbitrary index cut-off.
  • The performance differentials between small and large cap stocks, while biased in favour of large cap, have shown significant historical variability and this represents a greater opportunity for investors with broad-cap research capabilities to add value.

 

Greg Cooper is Chief Executive Officer at Schroders Australia. This article is in the nature of general information that does not consider the circumstances of any individual.

 

  •   12 April 2018
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

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

Australian large caps outperform small caps over long term

Right asset class, wrong index: the trap in Australian small caps

banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

The housing slide could become a crash

House prices are sliding across Australia, yet the most dangerous ingredient for a housing crash is still missing. If job losses surge amid growing economic risks, today's correction could become a historic property downturn.

Latest Updates

Testamentary trusts: Treasury has picked the wrong reading

A decades-old estate planning tool has survived one tax crackdown only to be caught by another. The surprise isn't who the reform is targeting, but who could end up paying the price for drafting choices made years ago.

Latest from Morningstar

Does an American retirement rule work for Australians?

The 4% rule has survived decades of scrutiny, but Australia's retirement system changes the equation in ways most overlook. Before accepting or rejecting this rule of thumb, it pays to understand what really drives retirement outcomes.

Shares

Glencore lands on the ASX. Should BHP and Rio shareholders switch?

A coal-heavy miner with governance concerns isn't the obvious choice for investors. Yet, Glencore's ASX listing may offer something BHP and Rio can't. The challenge is working out whether the opportunity outweighs the risks.

Why does the system treat capital gains and losses differently?

Investors are often told not to let tax policy drive their investment decisions. Yet, under the new CGT rules, portfolio construction, volatility and even how assets are owned may have an outsized impact on their final outcome.

Economy

Three common sense reforms that Australia needs

What do frozen bank accounts, mortgage traps and pension penalties have in common? They're all symptoms of a system that makes life much harder. Yet the obvious solutions seem to have escaped the attention of Canberra.

Shares

The hidden cost of government debt for investors

Some of the important effects of rising public debt never make the headlines. Research shows the immediate effects may already be unfolding, influencing corporate behaviour in ways that many investors would never suspect.

Investment strategies

When do fundamentals matter?

Is fundamental investing losing its grip on markets? Investors continue to search for valuation-based explanations for every price move, but the dominant force behind short-term returns may be something else altogether.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 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.