How to avoid missed investments opportunities experienced by Small Cap Index ETFs

Welcome to Finance and Fury, The Say What Wednesday Edition. Where each week we tackle questions from you – This week’s question is from Gab

Hi Louis, I have a question I’ve been pondering lately, around small-cap ETFs or LICs. It seems like the whole reason for investing in small caps (the fact that you can get high capital growth) is negated by the construct of such instruments. As an example, let’s say we have 40 small caps in one of these funds, statistically, only a handful of them will succeed, but the moment they grow, they would automatically be removed from the fund (at a profit, of course). This means you don’t get the opportunity to see 100x or 1000x benefit from a future Amazon or Facebook, because they got sold at 10x, while the poor performing ones still bring down the overall performance of the fund. What do you think? Is this a reason to avoid small-cap ETFs or LICs? Thanks, Gab

Great questions and points!

First – What is small-cap?
– The index, the S&P/ASX Small Ordinaries Accumulation Index, is comprised of companies included in the S&P/ASX 300 index, but not in the S&P/ASX 100 index – Normally the bottom 200 companies –

1. Accounts for approximately 7% of the market capitalisation of ASX listed equities.
2. The Small Ords is well diversified with all 11 Sectors represented
3. Not as top-heavy as the ASX300 – CBA makes up 7%, or top 10 making up 45%
   1. Between the 200 companies – largest allocation is about 1.5% – give more equal weightings
4. As Gab Mentioned – the whole point of smaller companies in the future growth potential –
   1. Small companies offer opportunity – most of today’s large and successful companies started small
   2. In their youth, companies often experience their greatest growth – and that’s often when returns can be greatest.
   3. Small-caps, therefore, are important portfolio growth assets, although they can be riskier and tend to exhibit higher volatility than established large-caps
   4. But once it cracks the top 100 index, it is no longer in the small-cap – so it is replaced and picked up by the ASX100 index

Look at the net effects of a handful of these gaining AUD 1,000%

1. Example – SARACEN MINERAL HOLDINGS LTD is share 101 in the index – market cap of $1.55bn (1.5% of index) – if it moves up a bit it will be out
2. Number 300 is Sundance Energy – Market cap of about $50m – makes up 0.05% of index
3. Invest $10k in the index – SEA would make up $5 of your holdings
   1. Say SEA rockets from 300 to 101 – 3,220% gain in the share = $5 into $166, which is good, but is a rare/extreme example

Brings on the issues with Index investing in the smaller cap

– Not a massive fan of Index ETFs in the small-cap sector – the exclusion of the shares

1. Shares get replaced – That is correct for small-cap Index ETFs/passive investments.
2. Lots of underperforming companies – take the good in the bad in the index
   1. The smaller cap has more bad than good – hence why they are large well-known companies
3. Very diluted holdings which minimise growth potentials – Similar to the SEA example – the largest gains don’t make much due to the nature of the index – diluted and the smallest companies now have the lowest initial allocation

Direct, Index v Active

– Smaller stocks are often considered a ‘stockpicker’s market’

1. The index exposure via Exchange Traded Funds are growing – and has been replacing active
   1. Small-caps opportunities can be easily missed – nature of small-cap means there is a lack of research coverage = many small-caps are ignored by analysts
   2. Small companies are often mispriced due to limited coverage
   3. Some are illiquid (low share turnover) because of a lack of popularity
2. Index selection – How are they selected
   1. Constituents are selected by their place on the Australian Securities Exchange (ASX).
   2. Easy cheap way of gaining exposure to small-cap – For this reason, investors looking for more reliable investment opportunities are turning to ETFs, which give the ability to access markets in a low-cost, efficient way – via a single trade on ASX.
3. Direct investing in small-cap – buying a handful of shares directly – This can make direct investments in small-caps a riskier game compared to investing in well-established large-cap stocks, for which there is ample research and analysis
   1. Fund managers have inside information as they go to these companies to do an analysis on the shares
4. But active fund managers have trouble mastering the small-cap sector.
   1. Over five years, 52 per cent outperformed – Finding reliable opportunities can be hard, but good managers do their jobs well
5. However, when comparing active managers in this space, the majority tend to outperform the Small Cap index over the longer term
   1. Long term performance of these managers does depend on the expertise of the analysts and the mandate.
6. Investment mandates are important – what a fund is allowed to do and what does it target? – value v growth
   1. The funds that I look at are typically considered ‘Future Leaders’ which allows them to continue to hold onto these companies even if they become ‘mid’ or ‘large’ cap managers.
   2. Something benchmark unaware – so if a share does become
      1. Avoids issues of If it was a passive index fund – where the share would be sold off out of the holdings
   3. Higher conviction is also important compared to index – holding 40 companies versus
7. When I put together smaller cap allocations – look for 3-4 funds that each play in a different space
   1. International and Australia – one growth manager and one value manager – that don’t pay attention to the benchmark and can be higher conviction – going overweight into small-cap companies that are likely to be good performers.
8. ETFs enable investors to have a broadly diversified exposure to small-caps, which reduces the cost and spreads the risks of investing in this sector – but it can create missed opportunities –

Thanks for the question,

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