Smaller companies are higher beta, but they need not be

From

Quan Nguyen

From time to time, the market reminds us of the inherent volatility of equities as an asset class. The December quarter of 2018 was a clear example of this, with the S&P/ASX 300 Index falling 8.4%; its largest quarterly decline since September 2011. However, the quarter was even tougher for smaller capitalisation stocks, with the S&P/ASX Small Ordinaries Index falling 13.7%. Zenith believes this comes as no surprise given historically, small companies have displayed higher beta (market sensitivity) relative to their larger counterparts.

Quan Nguyen, Zenith’s Head of Equities, noted that “The higher market sensitivity of smaller companies is generally underpinned by three main factors: higher concentration of unprofitable companies; lower liquidity; and a lack of research coverage.”

However, Zenith highlighted that an exposure to smaller companies can be gained without higher levels of market sensitivity when active management is employed. “Over the longer term, our rated active smaller companies funds exhibited market sensitivity levels that were either lower or similar to the broader market”.

Zenith noted that its rated Small Cap managers were able to generate an average excess return over the Index of 2.5% over the 12-month period ending 31 December 2018. One of the key aspects highlighted by Zenith’s research was the benefits of drawdown protection and the impact it can have on the subsequent recovery on an investor’s capital balance.

To illustrate this, an individual who invested $100 in a passive smaller companies index at its peak in October 2007, would see their investment fall to $90 as at 31 December 2018. In contrast, an individual who invested $100 in the average actively managed smaller companies fund rated by Zenith would have seen their investment grow to $179.

In addition, Zenith noted that during the Global Financial Crisis, its rated smaller companies universe of funds recovered from drawdowns significantly faster than the broader small cap market, with the average recovery duration being 25 months. The smaller companies index came close to breaking even in August 2018, however it remained underwater as at 31 December 2018.

Nguyen noted, “In general, smaller companies managers have participated fully in market upswings whilst also providing significant downside protection. We believe this highlights the benefits of active management, especially in less efficient segments of the market”.

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