November 26, 2019 Guy Carson

SHOULD YOU BE CONSIDERING SMALL CAPS IN THE CURRENT ENVIRONMENT?

BY GUY CARSON

The world of investing is consistently shifting. One of the big changes in this market cycle has been the rise of the profile of the capital allocators relative to active fund managers. Allocators have become the rockstars of the investment world and headline investment conferences. The reasons behind this are numerous but two stand out. Firstly, the unusual nature of zero interest rates and the unchartered territory of central bank policy naturally leads to more “Macro” conversation. Secondly, the rise of ETFs and passive investing has provided allocators with more tools and taken power away from active managers and stock pickers.

Active managers can’t really complain, they brought a lot of this on themselves. Through risk mitigation strategies, many managers tend to hug indices and charge active management fees. The result of this is that most managers underperform. Over the 10 years to December 2018, only 18% of managers in the US Large Blend category from Morningstar outperformed the S&P 500 and the average cumulative underperformance was 35.76%.

Of course if active managers on average produce such poor results, it makes sense to switch to passive management. Which allocators have done en masse.

Even active managers that tend to outperform in the large cap space have become frustrated. They tend to have higher conviction positions and can be susceptible to long periods of underperformance. These types of funds also frustrate allocators and short term underperformance can lead to outflows.

The result of this is that people have been buying markets and not companies. Passive investing feeds on itself. Due to the underperformance of active management, more money flows from active positions to passive. This drives indices higher and limits the ability of active management to outperform. Michael Burry of “The Big Short” fame has recently written about the distortion created by the rise of passive interesting and has gone as far as calling it a bubble.

JP Morgan recently estimated that Broad Index investing and ETFs now accounts for 75% of total equity trading. The death of Active Management has driven their share of trading volume down to below 10%.

If companies are not included in indices, liquidity has tended to disappear and valuation discrepancies in some cases have become extreme.

From the first chart above, one area where active management can add value is in Smaller Companies. Particularly where you can find a good manager who can take advantage of these valuation discrepancies. It is also an area that has been more and more ignored.

In addition as the US economy has clearly outperformed other major economy around the globe, more capital has flowed to the US and driven valuations up.

A valuation premium for the US is justified due to superior economics. But the discrepancy does mean that select opportunities can be found in international markets. If you combine the low valuations in international markets with the flows into passive investing you find that International Small Cap Managers have the greatest outperformance of any asset class.

The key in small cap investing is to be selective. If you can find the right manager, then significant outperformance is possible. Here at Southpac we have been working with our advisors to access top class international small cap opportunities. If you wish to discuss these opportunities please contact Guy Carson at gcarson@southpacgroup.com.

Disclaimer: The above contains the opinion of the author and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice

Guy Carson

Guy Carson is Southpac's Investment Specialist. Guy manages Southpac’s external relationships with investment advisors and banking specialists in client relevant jurisdictions around the world. In addition he works to clients to find the most appropriate solutions for their circumstances.
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