‘Boutiques with backing’ gain favour in Australian small cap universe

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Lonsec’s annual review of the Small Cap Australian Equity Fund sector found that boutiques – or, more accurately, ‘boutiques with backing’ – have continued to gain increased prominence as the preferred corporate structure of small cap investment teams.

Senior Investment Analyst Sam Morris commented, “Personnel changes have traditionally proved to be a persistent feature of the smaller cap universe, as talent looks to move if not sufficiently tied-in to overall business profitability or appropriately compensated.”

“In terms of the Lonsec peer group, approximately 50 percent of managers can be broadly classified as either an independent or boutique with the support of a cornerstone investor, such as Treasury Group, nabinvest or Challenger.”

There are a number of practical advantages in this business model.

“Key investment staff gain equity in the business, increasing alignment with investors and potentially their motivation for success,” said Morris.

“In addition, the investment team remains liberated to focus largely on investment functions, with things such as compliance, administration and distribution outsourced to the supporting backer.”

“Moreover, cornerstone investors provide much needed capital which brings stability in the early years of a new funds management business.”

Lonsec recognises that key person risk is a prevalent risk factor in many of the higher quality smaller companies products.

“Successful performance in this asset class is highly dependent upon the investment skill and experience of key individuals,” commented Morris.

“Nonetheless, Lonsec believes that key person risk is a risk worth taking and we recommend that consideration is given to the overall remuneration and incentive structure for key investment professionals.”

Smaller companies continued to struggle…yet fund managers restore faith in active management
The S&P/ASX Small Ordinaries Accumulation Index returned -23.4% in 2011, compared to the positive 13.1% gain in 2010. Despite this, the relative performance of small cap investment managers has been impressive, with the Lonsec Small Cap Peer Group outperforming the S&P/ASX Small Ordinaries Index by 8.3% over calendar 2011.

“This gives credence to the established view that the small companies universe is less efficient than the larger cap end, with few companies covered by brokers,” observed Morris.

“This enables professional investors to uncover attractive investment opportunities before being discovered by the wider market.”

As a result, Lonsec recommends active investment over passive strategies in this asset class.

“A well regarded small cap manager is likely to outperform the index through the cycle,” said Morris.

“Having said that, we are seeing more products coming to market offering beta exposure – although with such products, investors will be exposed to the full index – the good, the bad and the ugly.”

The perennial issue: how much is too much FUM?
Capacity is an issue that has long generated debate in the small cap sector. There is a divergence of views on the problems arising from too much funds under management – those managers with a large weight of money – such as BT, Perpetual and Acorn – are keen to talk down the negative aspects on the grounds that larger managers may:

  • Enjoy greater access to company management
  • Engender preferential treatment in IPOs or equity placements
  • Influence company direction through substantial status.

On the other hand, smaller players place greater emphasis on the limitations of a hefty weight of money suggesting that larger managers are:

  • Less nimble in the market
  • Unable to access small company opportunities or exit large positions
  • Inconvenienced by broader market awareness of substantial holdings.

“Generally, Lonsec believes capacity management is not a black and white issue – there are positives and negatives to low or high levels of FUM,” commented Morris.

“However on balance, we believe that managers with smaller FUM are better placed to add value and Lonsec’s higher rated managers will tend to be attractively positioned from a capacity perspective.”

The review
Lonsec’s Australian Equity Small Cap Sector Review encompassed 35 funds, of which seven attained Lonsec’s top rating of ‘Highly Recommended’. These included the Antares (Aviva Investors) Small Companies Fund, the Celeste Australian Small Companies Fund and the Perennial Value Smaller Companies Trust, all of which were upgraded as a result of this review.

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