For financial advisers and professional investors only – not for distribution to retail investors.
March 14, 2024
There are many ways to divide up equities: by sector, by country, by style. Company size is another approach, with global small market capitalisation, or “small cap”, companies presenting a very different proposition compared to the index heavyweights that traditionally dominate investor global equity allocations.
This insight highlights two key advantages global small caps can offer to an existing global equity allocation; the historical portfolio impact of adding global small caps; and some of the advantages of an active investment approach in the sector.
Small companies, big opportunities
Broadly, there are two advantages that global small caps can bring to existing global equity allocations in portfolios: the potential for higher overall returns, and increased sector diversification.
1. Potential for higher overall returns
Global small cap equities have historically outperformed their large-cap counterparts over the long-term. Since December 2000, the MSCI All Country World Small Cap Index has outperformed the MSCI All Country World Large Cap Index by +2.3% p.a. to 29 February 2024 (Chart 1).
This is a result of the inherent growth potential that small caps possess in contrast to mature large-caps – it is easier for an emerging business to double in size, for example, than an established market leader. Harnessing this growth potential alongside an existing global equity allocation therefore has the potential to increase overall returns at the portfolio level.
Chart 1: Performance of the MSCI All Country World, All Country World Large Cap and All Country World Small Cap indices, from December 2000 to February 2024
Past performance is not a reliable indicator of future performance. Source: Morningstar, MSCI, for the period from 31 December 2000 to 29 February 2024. Indices used are the MSCI All Country World NR Index in AUD, the MSCI All Country World Large Cap NR Index in AUD, and the MSCI All Country World Small Cap NR Index in AUD.
2. Increased sector diversification
Global small caps can also diversify the sector exposures of existing global equity allocations. The largest companies in most stock indices are generally industry incumbents, in sectors such as pharmaceuticals, technology, banking and energy. These companies may be sheltered from competition and new entrants by high barriers to entry or government regulation, or may benefit from significant pricing power or economies of scale. Small caps, by contrast, tend to be more cyclical and often operate in highly competitive market segments, including consumer retail, industrial machinery, biotechnology, construction, and real estate.
As at 29 February 2024, the most significant differences in relative sector weights between the MSCI All Country World Ex Australia Small Cap Index and the broader MSCI All Country World Ex Australia Index included a small-cap overweight to Industrials and a small-cap underweight to Information Technology (Chart 2).
Chart 2: GICS sector weights, as at 29 February 2024
Source: FactSet, as at 29 February 2024. Indices used are the MSCI All Country World Ex Australia NR Index in AUD and the MSCI All Country World Ex Australia Small Cap NR Index in AUD.
A look beneath the surface also reveals that global small caps can offer diversification of supply chain exposure. For example, while the small cap index has lower exposure to car manufacturers than the MSCI ACWI Ex Australia, it has a higher exposure to the components makers that supply the sector (Chart 3). Similar relationships can also be found in the Energy and Information Technology sectors.
Chart 3: Relative GICS Industry exposures of the MSCI AC World Small Cap Ex Australia Index, compared to the MSCI AC World Ex Australia Index, as at 29 February 2024
Source: FactSet, as at 29 February 2024. Indices used are the MSCI All Country World Ex Australia NR Index in AUD and the MSCI All Country World Ex Australia Small Cap NR Index in AUD.
Portfolio Implications
Historically, global small caps have produced higher long-term returns compared to large cap equities, while offering diversifying sector exposures, albeit to potentially more cyclical industries. From a portfolio construction perspective, it is therefore important to consider both the return and risk implications of allocating to small caps.
Since December 2000, each additional increment of global small caps (represented here by the MSCI All Country World Small Cap Index) added to an existing allocation to global equities (represented here by the MSCI All Country World Index) further increased portfolio volatility. Importantly though, investors would have been more than compensated for this additional volatility through higher risk-adjusted returns (Chart 4).
Chart 4: Return/risk characteristics of blending the MSCI All Country World Index and MSCI All Country World Small Cap Index, from 31 December 2000 to 29 February 2024
| Return (p.a.) | Standard deviation (p.a.) | Sharpe ratio | |
|---|---|---|---|
| 100% ACWI | 5.7% | 11.4% | 0.174 |
| 90% ACWI/10% ACWI Small Cap |
5.7% | 11.5% | 0.192 |
| 50% ACWI/50% ACWI Small Cap | 6.6% | 12.0% | 0.254 |
| 100% ACWI Small Cap |
7.6% | 13.2% | 0.305 |
For illustrative purposes only. Past performance is not a reliable indicator of future performance. Source: Morningstar, MSCI, for the period from 31 December 2000 to 29 February 2024. Indices used are the MSCI All Country World NR Index in AUD and the MSCI All Country World Small Cap NR Index in AUD.
A role for active management
While there is a compelling case for including global small caps in a portfolio, there is also a powerful argument for employing an active investment approach within the asset class. Active management works best when stocks are less efficiently priced, offering more opportunities for managers to exhibit stock selection skill. Small-caps are generally considered to be more prone to mispricing than large-caps, due to a lower level of coverage by researchers, analysts, and investors in the market. This results in lower consensus around the fair valuation for a company’s current operations, future growth opportunities and potential risks.
But while there is an opportunity for active managers, the challenge facing traditional fundamental investors, who may rely on in-depth company research and meeting with company management teams, is the sheer scale of the small cap universe – the MSCI All Country World Small Cap Index, for example, contains over 6,000 constituents. To this extent, a quantitative approach is particularly well suited to the task of applying active investment ideas across such a broad investment universe at speed and scale.
Arrowstreet, for example, relies on a scalable quantitative approach to systematically apply its unique investment insights, grounded in financial and economic theory, to an investment universe of over 10,000 listed companies, including small caps. A cornerstone of Arrowstreet’s process is its focus on indirect effects – the less obvious insights gleaned about a particular stock from other companies in the same sector or country, or identified by Arrowstreet as being economically-related, whether as a supplier, customer, or competitor. This provides a powerful and hard-to-replicate informational advantage that is particularly relevant for small-caps.
Conclusion
The global small cap equities sector has historically outperformed its large-cap counterpart, owing to its inherent growth potential, and offers increased sector diversification. These attributes have historically contributed to stronger risk-adjusted returns at the portfolio level.
Active management has the potential to enhance these outcomes further, by successfully exploiting the market inefficiencies in global small cap equities that result from a lower level of market coverage. Given the scale of the small cap universe, a quantitative approach may be particularly well suited to identifying such opportunities at speed and scale.
Australian investors can access Arrowstreet’s proven quantitative investment approach in a dedicated small cap strategy, via the Arrowstreet Global Small Companies Fund. Arrowstreet has significant experience in global small cap investing, illustrated by the performance of the Arrowstreet Small Cap ACWI Strategy, which since its inception in February 2009 has delivered an excess return over its benchmark of +4.4% p.a., net of fees (as at 31 December 2023). Since its launch on 29 August 2023, the Arrowstreet Global Small Companies Fund has outperformed its benchmark MSCI All Country World Small Cap ex Australia Index by a cumulative +5.6%, net of fees1 (as at 29 February 2024).
1 Past performance information is for illustrative purposes only and is not a reliable indicator of future performance.
Current performance information for the Fund is available on our website at macquarie.com/resources/fund-performance.
The Arrowstreet Global Small Companies Fund is designed for consumers who:
- are seeking capital growth and income distribution
- are intending to use the Fund as a minor allocation or satellite allocation within a portfolio
- have a minimum investment timeframe of seven years
- have a high or very high risk/return profile for that portion of their investment portfolio
- require the ability to have access to capital within one week of request.
Important information: The Target Market Determination (TMD), available at macquarie.com/mam/tmd, includes a description of the class of consumers for whom the Fund is likely to be consistent with their objectives, financial situation and needs.
Risks
All investments carry risk. Different investments carry different levels of risk, depending on the investment strategy and the underlying investments. Generally, the higher the potential return of an investment, the greater the risk (including the potential for loss and unit price variability over the short term). The risks of investing in this Fund include:
Investment risk: The Fund has exposure to share markets. The risk of an investment in the Fund is higher than an investment in a typical bank account or fixed income investment. Amounts distributed to unitholders may fluctuate, as may the Fund’s unit price, by material amounts over short periods.
Market risk: The investments that the Fund has exposure to are likely to have a broad correlation with share markets in general. Share markets can be volatile and have the potential to fall by large amounts over short periods of time. Poor performance or losses in domestic and/or global share markets are likely to negatively impact the overall performance of the Fund.
International, emerging and frontier market risk: The Fund has exposure to a range of international economies, including emerging and frontier economies. Global and country specific macroeconomic factors may impact the investments that the Fund has exposure to. Governments may intervene in markets, industries, and companies; may alter tax and legal regimes; and may act to prevent or limit the repatriation of foreign capital. Emerging and frontier markets may experience lower liquidity (including as a result of securities or bond markets being closed for extended periods), potential for political unrest leading to recession or war, greater potential for sanctions to be imposed on the country or its citizens, companies or institutions, increased likelihood of sovereign intervention (including default and currency intervention), currency volatility, and increased legal risk. These risks are heightened for frontier markets.
More information on the risks of investing in the Fund is contained in the Product Disclosure Statement, which should be considered before deciding to invest in the Fund.
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