Stephen Colwell

While Australian small cap funds have historically delivered outperformance against their collective benchmark at an impressive rate (85% of Zenith’s rated peer group outperformed over the last five years), since January 2022 they have lagged behind their large-cap counterparts.

In the rollercoaster ride of Australian small cap versus large cap performance, we see an intriguing pattern. There are periods of comparative underperformance followed by strong recoveries in the relative performance of our rated small-cap funds.

The secret sauce: Why small cap managers continue to deliver excess returns

There are several factors that go into the high success rate of active management in Australian small caps. One key driver is the pronounced market inefficiencies in this segment.  Unlike their larger counterparts, smaller companies stocks tend to be covered by fewer research analysts, meaning there is ample opportunity for active managers to identify mispriced stocks.

Picture this: BHP Billiton, with its colossal market capitalisation ($A 255 billion as at 31 December 2023), boasts 28 analysts scrutinising its every move, while little-known Weebit Nano ($A 803 million) flies solo with no analyst coverage.

Now, as of 31 December 2023, the average number of analysts covering constituents of the S&P/ASX 100 Index was approximately 70% higher than those covering the S&P/ASX Small Ordinaries Index. This asymmetry sets the stage for small cap managers to swoop in and uncover hidden gems. 

Navigating institutional headwinds

Small cap strategies have faced a number of headwinds in recent years. Potentially the most influential has been the wave of institutional funds which have meaningfully divested from the market segment, leaving a noticeable dent, as illustrated by the decline in both institutional funds under management (FUM) and the total number of individual mandates since 2019.

The reasons behind this retreat are multifaceted. It could be due to institutions pivoting with Your Future, Your Super (YFYS) performance test measures or simply changing asset allocation decisions. Regardless of the cause, the response has led to selling pressure on small cap companies.

However, there’s a silver lining.  The outflows of institutional funds has created room for retail investors to access longstanding and well-rated small cap strategies that were previously dominated by institutions. Additionally, this indiscriminate selling may have led to further market inefficiencies that can be exploited by active management.

The initial public offerings (IPOs) drought

Initial public offerings represent a promising avenue for potential returns for small and micro-cap funds. However, there have been limited opportunities in recent times. The numbers speak volumes. Since 2021 there has been a material decline in IPO activity.

Our analysis reveals a striking statistic: there were only two IPOs larger than $A 50 million in 2022 and only four in 2023. Comparing this to the 10-year average of over 20 IPOs annually, the magnitude of the decline becomes evident. Only time will tell whether these opportunities bounce back in 2024.

Where do fund managers believe the opportunities lie?

But where do the experts see the greatest potential for returns this year? We surveyed all rated fund managers within our Mid Cap Companies, Small Companies and Micro Cap Companies peer groups, to find out.

The responses provide a fascinating glimpse into market sentiment, ranking the most attractive market segments for 2024.

Despite the localised challenges of institutional outflows and the scarcity of IPO opportunities, there’s reason for optimism. With local inflation declining and interest rate cuts seemingly on the horizon, for investors,  perhaps active small cap managers are better positioned to capitalise on opportunities in 2024.

The post Finding the right small cap strategy in 2024 appeared first on AdviserVoice.

Stephen Colwell

Fee pressures have been felt across the Australian funds management landscape for over a decade. Whilst investors have benefitted from meaningful compression in traditional global long-only equities products, the global equities long/short peer group is often seen as an asset class that has withstood this trend.

The below graph highlights the median management fee of Zenith’s global equities long/short peer group and the average management fee of the long-only peer group over the most recent 10 years.

Having experienced many of the same industry dynamics as their long-only counterparts, the global equities long/short peer group has delivered a similar reduction in pricing. However, on the surface, it would appear the peer group remains significantly more expensive than their global equity long-only peers.

There is more to this than meets the eye. Let’s dig a little deeper.

Why do long/short funds charge a premium?

Long/short managers often operate with an absolute return focus, seeking to deliver a consistent level of return irrespective of the performance of the broader market. This can be achieved by dynamically adjusting the return and risk characteristics of the portfolio dependent on the current market environment.

This contrasts with the long-only peer group, which typically generates a return profile more closely linked to the broader market. The graph below highlights the significant return and risk divergence of the peer group, relative to the broader market (as represented by the MSCI World Index $A).

To achieve these outcomes, managers have differentiated areas of focus. For example, the dynamic adjustment of exposures requires putting additional resources into understanding the broader macroeconomic environment.

Investment opportunities also need to be identified at either end of the spectrum, both long and short. The required cadence of investment opportunities is often higher in short portfolios too, with short positions generally having a shorter life cycle. This is illustrated in the chart below, which compares the expected portfolio turnover of the global equities long/short and long-only peer groups.

As seen above, there is an expectation that the global equities long/short peer group will be considerably more active in adjusting its positioning.

Capacity constraints should also be considered. Long/short strategies are usually constrained by their short portfolios, where managers must maintain nimble short positions that can be exited quickly with limited market impact. Where long-only peers could generally manage significantly more in assets, their long/short counterparts cannot. This is highlighted in the below graph which compares the average capacity of the two global equity peer groups, as at 30 September 2023.

Of the two peer groups, the average strategy capacity for the global equities long/short peer group was $US 6.6 billion, 66% less than their global equities long-only peers. This places a limit on the profitability of an investment manager and results in a scarcity premium.

Are long/short funds actually expensive?

Many geared products available in Australia charge management fees on a gross asset value basis. Under this structure, the amount an investor pays in management fees increases as the amount of leverage applied increases. This differs from the fee structure applied to long/short managers, who apply a flat fee that’s unchanged by the amount of leverage applied.

In the example below, we have simulated the difference in management fees paid under net asset value and gross asset value structures, at different gross exposures.

Given the global equities long/short peer group typically run an element of leverage in their products, it would appear investors might be getting a better deal than the headline management fee suggests.

The chart below highlights the average gross exposure of the global equities long/short peer group over the most recent 10 years.

Despite the gross exposures of the peer group fluctuating materially on a product-by-product level, the peer group’s average exposure has remained relatively persistent. Over the period, the global equities long/short peer group has exhibited an average gross exposure of 126%.

Let’s level the playing field

Given the different levels of gross exposure maintained by the long/short and long-only peer groups, we need to neutralise this element for a more robust comparison of management fees. To assess this, we have equalised the global equities long/short peer group’s level of gross exposure to that of its long-only counterparts, reducing the management fees on a pro-rata basis^[1].

The below chart plots the adjusted median management fee of the global equities long/short peer group, assuming a reduction in gross exposure to 100%.

With two comparable datasets, we can isolate a more representative premium between the two peer groups. This is captured in the chart below.

Under this framework, the premium charged by the global equities long/short peer group falls substantially. When comparing the peer groups 2023 management fees, the premium contracts from 0.32% p.a. to 0.06% p.a. Additionally, we note that the premium has been in a state of consistent decline, from 0.22% p.a. in 2014 to 0.06% p.a. in 2023.

What about performance fees?

With our assessment focused solely on management fees, has there been a similar reduction in performance fees?

Thankfully, the days of 20% performance fees are gone, mostly, with the median performance fee of products that implement the structure having reduced to 15%.

Interestingly, whilst the performance fee charged has reduced over the past decade, the utilisation of performance fees across our APL has increased.

The chart below illustrates the increased use of performance fee structures over the past 10 years in the global equities long/short and long-only peer groups.

Whilst the prevalence of performance fees in each peer group remains materially different, we have observed a comparable increase in the utilisation of the structure, with the global equities long/short and long-only peer groups seeing increased utilisation of 23% and 16%, respectively.

Given the capacity constrained nature of the long/short peer group, we believe the utilisation of performance fees is appropriate. Tighter capacity constraints in the global long/short peer group ensure managers are focused primarily on investment returns, with outperformance made much harder if products are impeded by capacity limitations.

You get what you pay for!

Given the analysis above, we believe that the premium charged for global equities long/short funds is marginal, at best, but how have global equities long/short products performed on investment merit?

The below graph highlights the impressive defensive characteristics of the global equity long/short peer group, with an assessment of the peer group’s upside and downside capture ratios over the most recent 10 years.

Over the assessed period, the peer group captured an average of just 63% of the market’s declines. On the other hand, managers were able to participate in over 74% of market upside. Whilst hindsight is 20:20, we believe investors have been appropriately compensated over the assessed period with strong risk-adjusted returns.

The long and short of it…

While global equity long/short funds may appear relatively expensive at first blush, there is much more than meets the eye. As legendary investor Warren Buffett succinctly surmises: “Price is what you pay, value is what you get.”

By Stephen Colwell, Senior Investment Analyst

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Notes: [1]

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Stephen Colwell

Warren Buffett, billionaire investor and business magnate, is known for his shrewd financial acumen and philanthropic endeavours. But what does he have in common with Chris Hemsworth, Michael Jordan and Jennifer Lopez?

Outside of all being successful professionals in their own right, they are also middle children, the family member often stereotyped as overlooked or forgotten. Similar can be said for mid-caps, the ‘middle child’ of Australian equities, which has historically been an under-appreciated segment of the market. However, will this continue to be the case?

Flight to safety

Periods of economic uncertainty often drive investors to liquid and higher quality investments. Within the equities asset class, this is generally captured by a move up the market capitalisation spectrum. Given the market volatility over the 2022 calendar year, this dynamic was particularly apparent within the Australian equities market.

What about mid-caps?

The chart below illustrates the rolling annualised 12-month performance differential between the Australian mid-cap companies (S&P/ASX Mid-Cap 50 Index) and Australian smaller companies (S&P/ASX Small Ordinaries Index) segments since 2000.

Source: Bloomberg

Whilst smaller companies sold off meaningfully in the 2022 calendar year, both mid-cap and larger companies offered investors a degree of downside protection.

How are small-cap managers positioned?

While smaller companies funds are restricted from gaining exposure to the larger companies segment of the market, exposure to the mid-cap segment is typically permitted to an extent. Within the context of our rated small companies funds, mid-cap exposure has been trending upward over the last five years, as illustrated in the chart below.

Source: Fund Managers

Smaller companies funds are typically required to sell-down securities that graduate into the mid-cap market segment. However, some managers maintain the flexibility to keep positions over a certain period or may be allowed to retain exposure up to a predetermined limit. For this to occur, we would expect to see one of the following three factors:

1. Letting winners run – Managers maintain positions in stocks that have graduated into the mid-cap segment. These positions typically require stock upside to remain in the funds.
2. Search for quality – Certain industries, whilst represented in the smaller companies universe, may be uninvestable due to a lack of quality companies or illiquidity. In such cases, managers may hold mid-cap positions for diversification and/or risk management reasons.
3. Relative attractiveness of mid-caps – Changes in market conditions may mean certain segments are more attractive from a valuation perspective or offer higher growth opportunities.

We’ve noted there have been several smaller companies funds that have adjusted mandate constraints, over the past two years, to allow for increased levels of mid-cap exposure. 

Dedicated allocation to mid-caps?

Historically, mid-cap funds in the Australian market have been underrepresented relative to their larger and smaller-cap peers. However, we’ve observed strong growth in the number of offerings in our Australian Shares – mid-cap companies universe over the last four years. The following chart highlights the number of products within the peer group from 2018 to 2022 and the corresponding funds under management (FUM) levels.

Source: Fund Managers

In conjunction with the growth in available products, there has also been considerable growth in FUM of the underlying strategies. Whilst negative market performance was a headwind to FUM throughout 2022, in the preceding three-year period total assets grew by over 100% to more than $A 18 billion.

For retail investors seeking a dedicated mid-cap exposure, the breadth of options has never been better!

From middle child to golden child?

In summary, if you want the stability and quality of larger companies and the upside potential of smaller companies, there is clearly a robust case to be made for mid-caps. With the strong growth of investment options in this previously underrepresented market capitalisation segment, it appears that the overlooked middle child is quickly becoming the golden child.

By Stephen Colwell, senior investment analyst

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Stephen Colwell

Years before he became a billionaire hedge fund manager, William “Bill” Ackman, founder of Pershing Square Capital Management, trekked 10,000 kilometres to go fishing. Although Ackman had never fished a day in his life, the trip was a success due to his guide, Oliver White.

While White had no prior knowledge of the investment industry, his ability to find fish was key to impressing Ackman. Drawing upon a wise teaching of legendary investor, Charlie Munger, “the first rule of fishing is fish where the fish are”, Ackman offered White a role in his investment team.

Where’s the best place to fish in Australian equities?

The best fishing spot for active managers is the Australian small cap pond, which is represented by the S&P/ASX Small Ordinaries Index. A diverse and under-researched opportunity set gives an active manager the best chance of outperforming. The chart below highlights the persistent outperformance profile of our rated small cap managers.

What’s accelerated this outperformance in recent years?

The Australian small cap universe is dynamic and diversified, and increasingly so. Over the past five years, constituent changes for the small cap index have gradually increased, reaching a peak of 55 in 2021.

We also found that over 50% of constituents in the small cap index were not there five years ago, equating to over 100 new opportunities for investors. That’s a lot of new fish! The refresh rate was almost double that of the large and midcap benchmark, as represented by the S&P/ ASX 100 Index over the period.

Where are the new fish coming from?

These new opportunities can come from a variety of channels, including initial public offerings (IPOs), whereby a company issues its shares publicly on an exchange. Over the past five years, investors have seen an average of 110 new companies list per year, which are typically opportunities that fall within small and microcap managers’ universes, due to liquidity and size constraints.

The 12 months to 31 December 2021 were particularly busy for IPO activity on the Australian Stock Exchange with almost 200 companies listing, more than doubling that of 2020.

Another channel for new opportunities is through index constituent changes. Specifically, microcap companies graduating to small caps and midcaps falling into small caps. More on this later.

A third channel is through corporate activity, which generally comes in the form of emerging and smaller companies being acquired. When stocks are removed from the index, it’s replaced at the next index reconstitution, leading to further opportunities for active investors.

Afterpay is a great example of a company that passed through all the channels above. It was listed in 2016 and grew rapidly, which led to it eventually being promoted to the large cap index. In 2022, it was acquired by US payment giant, Block (formerly known as Square).

Plentiful fish = strong excess return

The law of active management suggests that managers are better positioned to generate excess returns with greater investment breadth, holding all else equal. That is, the higher the ‘effective’ number of holdings in an index, the greater the investment breadth.

The chart below shows the change in the effective number^[1]of stocks within the small cap index over a five-year period to 31 December 2021.

Although the small cap index typically comprises approximately 200 stocks, the diverse nature of the index results in an effective holding of 148 equally weighted stocks, as at 31 December 2021. Compared with five years ago, when the effective number of holdings was 128, there’s been a material increase in breadth and diversity in the index, which improves an active manager’s ability to generate outperformance.

How does this compare to large caps?

Taking the S&P/ASX 50 Index as a representation of large caps, we find that the dynamics are very different.

The effective number of stocks within the large cap index was 23 (or approximately 45% of 50 stocks in the index) in 2021, which remains virtually unchanged since 2017.

You’re promoted!

How do stocks perform when they get promoted from the small cap index to the midcap index?

The chart below shows the one, two and three-year median outperformance of stocks graduating from small caps (S&P/ASX Small Ordinaries Index) to midcaps (S&P/ASX MidCap 50 Index).

Over a one-year period, promoted stocks experienced a median outperformance over the small cap index of over 6.0%. We believe this short-term outperformance is driven by structural reasons, such as continued momentum from passive index funds buying as stocks enter mid and large cap indices.

However, promoted stocks typically underperformed following the initial 12-month period, which we consider to be underpinned by structural issues.

The small cap fund manager universe in Australia is significantly more mature than its midcap counterpart. This dynamic has the effect of leaving promoted stocks stranded, no longer available to small cap funds and unable to be supported in a material manner by midcap funds.

To remain true to label, small cap funds are typically mandated to divest stocks that get promoted within a certain time frame, which is generally set at 12 months. We believe this time frame ensures that small cap funds remain true to label and allows investors to benefit from the capital gains discount.

Oh, and you’re demoted…

If promotions result in short-term outperformance, is the opposite true for demotions?

We found that this assertion is false for midcap stocks that are demoted. The chart below shows the performance profile of demoted mid cap stocks.

Over a one-year period, demoted stocks experienced a median outperformance over the small cap index of over 10%. There’s an immediate tailwind associated with small cap funds becoming eligible to buy these companies once again, especially given demoted stocks can (and often do) have a meaningful weight in the benchmark.

Australian small caps – the place for active managers to fish!

After putting in 100-hour work weeks at Pershing Square Capital Management, White moved back to the Bahamas, seeking the best fishing waters in the world.

Using his newly acquired skills, he found an old, dilapidated hotel, and made his vision to build a fishing lodge a reality. With Ackman as his backer, White created a highly profitable business, hosting high profile visitors and the ESPN fishing show, Pirates of the Flats.

The playbook for our rated Australian small cap managers is similar – fish for attractive opportunities in some of the best waters in the world.

By Stephen Colwell, Senior Investment Analyst

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[1] Calculated by 1 divided by the Herfindahl-Hirschman Index

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