Investors who are used to the success of local small cap managers will be surprised to discover it doesn’t always work the same way at the global level.
Morningstar’s latest research says active fund managers in the global small cap sector struggle to consistently outperform mainly due to their lack of local knowledge among other challenges.
The average performance of global small cap funds available in Australia compared with the MSCI World Small Cap Net Return Benchmark showed outperformance only 24 per cent of the time over a three-year period.
Morningstar’s associate director, manager research Michael Malseed says: “The bottom line is small-cap investing is fraught with risks, and managing these risks becomes more difficult when dealing across multiple geographies and currencies.
The challenge for managers is that small caps often have concentrated risk across customers, suppliers, and economic exposure compared to large caps.
Malseed says: “It is difficult for small teams to get close enough to companies across multiple geographies. The manager loses the ability to regularly ‘walk the floor’.”
In addition, small caps are less resilient to market shocks whereas large-caps can easily raise capital if needed.
Malseed says: “Pristine balance sheets can evaporate quickly when earnings turn south, resulting in a higher risk of going out of business completely. This means the cost of a company’s failure for a concentrated, actively managed global small-cap portfolio is high.”
The research house warns that small caps are vulnerable to macroeconomic, geopolitical and currency risk whereas large companies have some diversification at an operational level.
Malseed says: “Bottom-up fundamental stock-pickers often admit they do a poor job of forecasting macro trends, and this is a skill set that is even more rare among global small-cap managers where the risks are even higher.”
Despite the proposition for investing in small caps appears positive from the outset due as they can outperform large caps in the long run.
Smaller companies are under-researched compared to global corporations which allows the opportunity for a skilled fundamental manager to exploit incorrect pricing.
Malseed says: “While the annual reports and accounts of mega-corporations are pored over by armies of analysts, many small caps are ignored.”
Morningstar recommends global small-cap with large global teams and multiple local presences, such as Lazard Global Small Companies
It says Dimensional Global Small Companies Trust takes an approach to diversify away from idiosyncratic risk. And it likes the passive index option of Vanguard International Small Companies.