For financial advisers and professional investors only – not for distribution to retail investors.
March 2024
By Luis Sarmiento
If you only have one minute…
Small-cap companies are trading at the most attractive valuation discount compared to large- and mid-cap equities in over two decades, but some investors may be wary of taking advantage of this opportunity due to the higher volatility of the sector amid ongoing economic uncertainty. Arrowstreet’s scalable quantitative approach aims to deliver consistent small-cap alpha to client portfolios irrespective of ever-changing market conditions.
Valuation opportunity
Small capitalisation companies, or small caps, have traditionally traded at a valuation premium to their larger counterparts. This is due to their inherent growth potential – it is easier for an emerging business to double in size, for example, than a sizable incumbent – which has historically contributed to their long-term outperformance of established, mature large-cap companies.
However, Exhibit 1 highlights that this relationship broke down following the Covid market drawdown in early 2020, with the stellar performance of mega-cap technology stocks, predominantly in the US, driving overall market returns and boosting valuations, and transforming the small-cap premium into a small-cap discount. This valuation gap represents one of the most attractive investment environments for small caps in over two decades.
A role for active management
At the same time, some investors may be wary of allocating to small caps as a sector amid an uncertain economic environment. Alongside their growth potential, small caps are also more connected to the market cycle, owing to their higher exposure to the industrials, real estate, and materials sectors in particular. This highlights the role an active global small-cap manager can play – harnessing the latent growth opportunity available in small caps, but being more selective to deliver excess returns to client portfolios irrespective of market conditions.
Investment approach and implementation are important considerations. Traditional fundamental investors, who may focus on in-depth company research and meeting company management, must confront the sheer scale of the small-cap universe, with the MSCI All-Country World Small Cap Index containing over 6,000 constituents. By contrast, a systematic quantitative approach is well suited to the task of applying active investment ideas across such a broad investment universe at speed and scale.
Exhibit 1: FactSet forward 12-month P/E ratios for the MSCI All Country World Index and MSCI All Country World Small Cap Index, from 30 June 2007 to 29 February 2024
Past performance is not a reliable indicator of future performance. Source: Macquarie, FactSet, MSCI, for the period from 30 June 2007 to 29 February 2024. Indices used are the MSCI All Country World NR Index and the MSCI All Country World Small Cap NR Index. The Benchmark of the Arrowstreet Global Small Companies Fund (the “Fund”) is the MSCI All Country World Small Cap ex Australia Index, in $A unhedged with net dividends reinvested.
Small companies, Big Data
Arrowstreet’s investment process, for example, relies on a scalable quantitative approach to systematically apply 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. Arrowstreet’s quantitative implementation provides a powerful and hard-to-replicate informational advantage that is particularly relevant for small-caps, which generally receive less attention from investors and reduced broker coverage, and so can be more prone to mispricing.
Australian investors can now access Arrowstreet’s investment approach in a dedicated small cap companies strategy through the recently launched Arrowstreet Global Small Companies Fund. The Fund employs the same investment philosophy and dynamic approach successfully used by the Arrowstreet Global Equity Fund since 2006. 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 fees (as at 29 February 2024).
Authors
About Arrowstreet
Arrowstreet Capital, Limited Partnership (Arrowstreet) is an independent private partnership that serves as a discretionary institutional global equity manager. Arrowstreet is wholly owned and controlled by members of the firm’s senior management and non-executive directors. Arrowstreet was founded in June 1999 and its principal place of business is located in Boston, Massachusetts.
* Benchmark is the MSCI All Country World Small Cap Index. Net-of-fees returns are arrived at by deducting management fees from the calculated gross returns, which are net of trading expenses and other applicable expenses or fees. The performance has been included to illustrate the track record of the manager in managing the strategy described in this article. The strategy performance is provided for illustrative purposes only and does not represent the actual or prospective returns, or the theoretical historical returns of the Arrowstreet Global Small Companies Fund. This information has been prepared by Macquarie Investment Management Australia Limited (ABN 55 092 552 611 AFSL 238321) the issuer and responsible entity of the Fund referred to above.
The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
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.
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The Fund(s) mentioned above may have multiple classes of units on issue. A separate class of units is not a separate managed investment scheme.
This information has been prepared by Macquarie Investment Management Australia Limited (ABN 55 092 552 611 AFSL 238321) the issuer and responsible entity of the Fund(s) referred to above. This is general information only and does not take account of investment objectives, financial situation or needs of any person and before acting on this information, you should consider whether this information is appropriate for you. In deciding whether to acquire or continue to hold an investment in a Fund, an investor should consider the product disclosure statement for the relevant class of units in a Fund, if any, and the Website Disclosure Information available at macquarie.com/mam or by contacting us on 1800 814 523.
Nothing in this document constitutes a recommendation to buy, sell or hold any financial product, security or instrument.
Future results are impossible to predict. This document contains opinions, conclusions, estimates and other forward-looking statements which are, by their very nature, subject to various risks and uncertainties. Actual events or results may differ materially, positively or negatively, from those reflected or contemplated in such forward-looking statements.
Past performance information shown herein, is not a reliable indicator of future performance. No representation or warranty, express or implied, is made as to the suitability, accuracy, currency or completeness of the information, opinions and conclusions contained in this document. In preparing this document, reliance has been placed, without independent verification, on the accuracy and completeness of information available from external sources. To the maximum extent permitted by law, no member of the Macquarie Group nor its directors, employees or agents accept any liability for any loss arising from the use of this document, its contents or otherwise arising in connection with it.