Targeting Australian Small Cap Manager Alpha

 

SQM Research rates several Australian small cap managers with Ausbil being one of higher rated funds in the sector. The realm of small-cap stocks is known for its potential to deliver outsized returns, but with this opportunity comes heightened risk due to the nature of smaller listed companies. As the economy moves through its cycle and we get closer to economic recovery many investors will choose to take a tilt toward small-cap companies which tend to perform well during economic recovery. Other investors will maintain strategic exposure to small companies for their long-term propensity to outperform.

When we look at investing through fund managers a risk investors face when choosing a manager is the dispersion of returns between the best and worst managers in any one year. This phenomenon is especially evident in Australian Small Company funds, where the potential for excess returns relative to benchmark indices like the S&P/ASX Small Ordinaries Index is present, but with substantial variation. As the chart below shows selecting a single manager can result in significant outperformance or underperformance, so how should investors think about getting exposure to small Australian companies? In this article, we delve into the significance of diversifying exposure in Australian Small Company funds, considering the historical data that highlights both the allure and challenges of this investment arena.

Dispersion refers to the spread of returns within a given category of investments. In the context of Australian Small Company funds, dispersion highlights the variance in returns among different fund managers and individual small-cap stocks. Excess returns, on the other hand, denote the performance of an investment beyond what could be achieved by simply holding a benchmark index. In this case, we're examining the excess returns relative to the S&P/ASX Small Ordinaries Index.

The historical data on Australian Small Company funds reveals the rollercoaster nature of these investments. With excess returns ranging from 116.3% to -49.6%, with an average excess return of over 5% since January 2000 and 4% in the last 10 years, it's evident that the potential for high rewards is often accompanied by the potential for significant losses. This volatility can be attributed to the inherent characteristics of small-cap stocks, which often lack the stability and analyst coverage of larger companies. For the 12 months ended June 2023 the maximum excess return was delivered by Hyperion Small Growth Companies with an excess return of 23.6% however in February 2002 it was the worst performing small cap manager delivering -28.9% underperformance of the Small Ordinaries TR Index and just last year as of April 2022 it had delivered -20.2% to the benchmark. The worst fund for the 12 months ending June 2023 was Saville Capital Emerging Companies with an underperformance of -33.2% however this had been the best-performing fund in March 2021 delivering 116.3% outperformance in the preceding 12 months. So how should investors think about their strategic exposure or their tactical tilts to small companies?
 
The Case for Diversification
Diversification is a fundamental principle of investing, and it becomes even more crucial when dealing with assets characterized by high dispersion. By spreading investments across a variety of assets, the impact of poor-performing stocks or fund managers on the overall portfolio is mitigated. In the context of Australian Small Company funds, diversification can help investors manage risk while still pursuing the potential for high returns.

The historical data reinforces the merit of diversification in this space. Consider a scenario where an investor placed all their capital in a single small-cap stock or fund manager. Depending on the timing and specific choice, they could have experienced exceptional gains or substantial losses. However, by diversifying across multiple funds, the overall impact of extreme outliers is reduced, leading to a more stable and potentially profitable investment journey. Notwithstanding the survivorship bias in the data, a mix of four or more small-cap managers can reduce the likelihood of an investor experiencing underperformance of the S&P/ASX Small Ordinaries in the Small-Cap portion of their portfolio.

**Conclusion**

Investing in Australian Small Company funds offers the potential for significant excess returns, but it comes with challenges due to the wide dispersion of returns and the inherent volatility of small-cap stocks. Diversification emerges as a key strategy to navigate this landscape, allowing investors to manage risk while capitalizing on the potential for growth. By spreading investments across multiple funds, the impact of extreme outliers is reduced, providing a more stable investment experience.

However, investors should also recognize the role of probabilities and the inherent uncertainty in the market. Past performance is not a guarantee of future results, and the complex interplay of economic, market, and managerial factors means that outcomes can vary widely. As such, a thoughtful and diversified approach that aligns with an investor's risk tolerance and long-term goals is crucial when considering Australian Small Company funds or any investment in the stock market.