Investing

Small-cap funds are frequently one of the top-performing asset classes, and the fact that they can perform so well says much about the quality of the top small-cap stock pickers – and the heavy concentration of big bank and resources stocks in the top 100 companies, which creates more pricing inefficiencies and opportunities in badly under-researched small-cap stocks.

More than 70 per cent of Australian equity small-cap funds beat the Small Ords in the five years to December 31, 2010, Standard & Poor’s SPIVA report found. The figure was almost reversed for Australian equity general funds, where a majority underperformed the S&P/ASX 200 Accumulation Index.

The average small-cap fund returned 7.99 per cent annualised over five years, compared with 5.54 per cent for the Small Ords.

The outperformance is less impressive after fees: small-cap funds typically charged higher annual and performance-related fees than large-cap Australian equity funds.

Nevertheless, a sustained period of outperformance during the financial crisis, which slaughtered the share prices of many small companies, and during a mining boom creating complications for valuation-based stock pickers, is an impressive result for the small-cap fund segment.

There is an argument that small-cap stocks, which historically lead market recoveries, might have seen their best days for now. They were the best-performing listed asset class in 2003, 2006, 2007 and 2009, Morningstar research shows. Rarely does one asset class have such strong relative outperformance against others in consecutive decades.

There is no shortage of top-down arguments suggesting the potential rewards from small-cap funds may not be commensurate with their higher risk and volatility in the next year or two. But generalisations are always dangerous in small-cap land. This is a market for stock pickers not index huggers or investors who obsess about aggregate P/E valuation arguments.

Top small-cap fund managers outperform in different markets. If anything, the S&P research showing so many large-cap Australian equity funds underperformed their index is an argument to get more core portfolio exposure to large-cap stocks through low-cost index funds or listed investment companies (LICs), and use small-cap active funds as portfolio “satellites” to outperform the market and create “alpha”.

Investors need to work harder than ever to choose the right small-cap managers. The following tips will help you narrow the field.

Top 10 tips for choosing small-cap funds

1. People An experienced team is important. The sector is volatile and requires a stock-picking focus, rather than a reliance on trends.

2. Process Each fund chooses stocks differently but a focus on getting valuations right and conducting company visits counts.

3. Performance Look at returns over one to five years, or longer, and compare them with the Small Ords Index. Take care with funds open for less than five years. A limited history means you cannot assess how they perform through cycles.

4. Holdings Check the top holdings. Is there an emphasis on resources or industrial shares? Are there many exploration companies?

5. Turnover Funds that turn over most of a portfolio each year have a trading focus – which can mean higher costs and capital gains tax.

6. Fees An average small-cap fund might charge 1 per cent or more annually and a performance fee of 10-20 per cent. Some funds justify high fees, others don’t.

7. Size matters Some larger funds find it harder to outperform because their size forces them to take bigger positions in less liquid stocks.

8. Rating services Use research from groups such as van Eyk, Lonsec, and Morningstar. Gain an understanding of how they rate funds.

9. LICs Listed investment companies require more analysis. Much of the above applies, but also consider a fund’s premium or discount to net tangible assets against its five-year average – the ASX has monthly reports. Brokers also do research.

10. Aggregate valuations Watch the average forward P/E ratio. Consider reducing holdings if small-caps trade at parity or a premium to blue chips for lengthy periods.