Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 215

The investment bias against small companies

Since the financial crisis, the risk/return relationship that underpins the accepted investment wisdom in Australian equities has been challenged. The funds of median smaller company managers are showing lower levels of volatility and price falls in market pullbacks.

This article considers several explanations for the lower risk across smaller company managers and whether we could expect this to continue.

Risk and return of large and small cap median managers

To analyse the different risk/return characteristics of broad cap (ie the entire market) and small cap (ie smaller companies) managers, we have used the monthly median Australian fund manager returns since 1990. Managers are split using the Morningstar classifications of broad cap or small cap from all the available retail funds in the Morningstar database. Using point in time monthly data removes survivorship bias, and all returns are recorded after fees.

Figure 1 below charts the risk/return characteristics of the broad cap manager compared to the small cap manager over multiple time periods. Over longer time periods (10-20 years), the traditional risk/return theory holds. However, over the shorter time period (5 years) the median small cap manager has experienced superior return at lower levels of risk.

Figure 1: Risk and return characteristics of Australian equity funds

Source: Morningstar, Fidante Partners

Have the risks in larger companies changed?

Whilst volatility should retreat after the generational losses seen in 2007-2009, the volatility of larger company manager portfolios has not reduced at the same pace as smaller company manager portfolios.

Economic sensitivity is generally considered to be higher in smaller companies. This is a reason why these stocks will at times underperform when economic conditions deteriorate. However, analysts may be underestimating the impact on the large end of the Australian stock market from low economic growth due to the sector concentration and the increasing use of new ETF structures that are impacting how large-cap equities are held and traded.

Large companies need economic growth

The long-term growth potential of the stock market is dependent on the level of nominal gross domestic product (GDP). With consumption growth weakened, investments curtailed and the government attempting fiscal prudence, growth has been restrained.

Larger companies especially will more likely proxy and mimic the growth of the broader economy. Larger companies have collectively benefitted on the one hand from falling interest rates and benign cost inflation, however, these benefits are symptoms of a lacklustre growth environment. As proxies for the domestic economy, the aggregate of the larger company market has struggled to achieve strong real organic growth.

For smaller companies, the problem of growth is a different one. Growth rates are more commonly defined by the operational and strategic success of the business. That is not to say that many smaller companies have themselves not had their own challenges, but there generally is more organic growth potential.

Figure 2: Australian GDP

The smaller company market is structurally diversified

Australian funds management is dominated by a handful of bank financials and resource names comprising over 50% of the S&P/ASX300 index. Whilst an active manager can produce a well-diversified portfolio in Australian larger companies, it necessitates the manager hold a very different looking portfolio to the index.

The concept of index concentration in smaller companies is less, if non-existent, without the stock concentration and sector concentration, as shown in Figure 3. An obvious point maybe, but the smaller company universe has a pressure valve, where concentration risk is reduced as stocks move up and out of the index. Whilst a bubble may have its origins in the smaller company universe, it is likely in the large-cap index where the bubble will take hold and do the most damage.

Figure 3: Composition of Australian broad cap and small cap market indexes as at 30 June 2017

In addition, as investors use of ETFs, thematic factor buckets and other pseudo market proxy strategies increase, a lot of stock trading is largely unrelated to the condition of the underlying instruments. The holding period for many stocks is now measured in days and weeks, which is inconsistent with real investing. Liquidity requirements of ETF structures and the belief in the market proxy disproportionally affects larger companies. 

Role in portfolio construction

The analysis of risk-adjusted returns (as measured by the Sharpe Ratio, which is approximately return divided by risk as measured by volatility) of blended small and broad cap median managers shows over the last 20 years, the most efficient portfolio is one which includes 100% smaller companies. This is a theoretical exercise and in practice behavioural biases and preferences of an individual will dictate if an investor can tolerate increased volatility. However, the chart below shows it is possible to incrementally allocate to small caps (below 50%) without meaningfully increasing the overall risk of a blended portfolio.

Figure 4: Portfolio construction: Blending large and small company managers

Source: Morningstar, Fidante Partners

For example, in Figure 4, the blue triangle with the lowest risk and return is 100% allocation to large companies. The blue square is 50% large and 50% small companies, with a significantly larger increase in returns than risk, and hence an increase in the Sharpe Ratio.

Over the last 20 years, whilst little has changed in the smaller company market, a lot has changed in the larger company market. The combination of low economic growth, sectoral concentration and the size of the transient short-term trading may require the investor to carefully consider their exposure to smaller companies versus larger companies.

 

Tim Koroknay is an Investment Specialist at Fidante Partners. Fidante is a multi-boutique asset manager which includes two small companies fund managers, NovaPort Capital and Lennox Capital Partners. Fidante is a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any individual.

RELATED ARTICLES

Three small companies expected to deliver big returns

Six COVID opportunist stocks prospering in adversity

Why caution is needed in Aussie small companies

banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 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. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.