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.

 


 

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

Is now the time to invest in small caps?

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Latest Updates

Taxation

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

7 key charts on the state of the Australian property market

The Australian property market stirs fierce debate - often bullish optimism versus crash predictions. But beyond the noise, seven charts reveal what's really driving prices and the outlook for residential real estate.

A simple alternative to the $3 million super tax

Division 296 aims to introduce improved fairness into the superannuation system, yet is overly complex. This scours the world for better ideas and suggests a simpler alternative which can achieve the same goals.

CBA and the index conundrum for super funds

After the hyperbolic rise in CBA shares, super funds are floating the idea of carving out the weightings of ASX bank securities and indexing them within their portfolios. This looks at why that might be a big error.

Strategy

10 policies to drive Australian productivity higher

Here's a comprehensive list of proposed reforms to fix Australia's stagnating economy, including introducing a flat income tax rate, reducing migration, and making childcare tax-deductible.

Interviews

Where to find big winners in Asia

As more money looks for a home outside the US, Asia may soon get some love. Fidelity's Anthony Srom outlines the best places in Asia to invest, including in Chinese consumer names, Indian financials, and Thailand.

Investment strategies

We have trouble understanding the time value of money

We overvalue the present and underestimate the future - it’s a cognitive glitch called hyperbolic discounting. It affects savings, spending, and loans, and it's more common - and costly - than we think. 

Sponsors

Alliances

© 2025 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.