Active managers have the edge with Aussie small caps

Much has been written about Australian large cap fund managers’ failure to consistently outperform the ASX 200. But investors may be wrong to avoid active management across all asset classes.

A new report from Morningstar fund analysts shows that over the past decade, most active small cap Australian equity managers have handily beaten small-cap indexes.

Analyst Edward Huynh says active managers have greater opportunities to capitalise on under-researched companies and avoid small speculative stocks—a flexibility that passive strategies lack.

"Active fund managers have outperformed the Australian small-cap benchmark over several years, the only sector where nearly all active strategies have beaten the index consistently," Huynh says.

"There have been periods where the index has beaten active managers, but this is rare and generally coincides with low-quality cyclicals rallying, which active managers generally avoid."

For this reason, Australian equity small/mid cap index-tracking ETFs under Morningstar coverage, including the Vanguard MSCI Australian Small Coms ETF (VSO), the iShares S&P/ASX Small Ordinaries ETF (ISO) and the SPDR S&P/ASX Small Ordinaries ETF (SSO), typically carry a Neutral rating.

Instead, analysts have expressed their preference for several active medallist managers, including the gold-rated Pendal Small Companies fund and the silver-rated Hyperion Small Growth Companies fund.

Analysts believe indexing is a reasonable approach but recommend that it is best used as a supporting strategy.

Morningstar's medallist small-cap fund performance, 10YR, 1/07/2010 - 30/06/2020

Source: Morningstar Direct

While domestic small-cap managers have shown their ability to beat the S&P/ASX Small Ordinaries benchmark long term, Morningstar associate director, manager research, Michael Malseed says the same cannot be said for global small-cap strategies beating the MSCI World Small Cap benchmark. This is especially true for smaller teams investing across many countries, he 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.

"Small teams are likely to struggle to stay abreast of localised issues, increasing the risk of being caught by idiosyncratic shocks, and constraining the ability to outperform with a high degree of consistency."

Small cap value underperforms in FY20

Returns over the last financial year have been mixed. Small cap growth manager Hyperion Small Growth Companies streaked ahead of the pack delivering returns 21 per cent above the S&P/ASX Small Ordinaries Total Return index at 15.36 per cent for the year.

Its nearest rival, Bronze-rated Bennelong ex-20 Australian Equities fund, returned 8.13 per cent.

On the opposite end, Silver-rated value manager Investors Mutual WS Future Leaders underperformed the index by -9.16 per cent, delivering returns of -14.83.

Morningstar senior analyst Ross Macmillan says Hyperion and Bennelong host impressive and highly experienced teams that deliver strong long-term returns. However, he says both have also benefited from the outperformance of growth stocks over value in a turbulent market.

"The thing that's favoured them is their growth investment philosophy," he says.

"If you look at who among large and small cap managers that have underperformed over the last five years, it's mainly been value. Growth has trounced value.

Macmillan says traditionally you'd expect value stocks to be in their element in a market crash. But this time round, we've seen the opposite.

"In the pandemic stock market rebound, growth stocks are leading the way across the board, in healthcare, technology, and buy-now-pay-later stocks – many of which are trading on quite large multiples.

"The value managers look at them and say I can't buy that stock on a valuation basis, but the growth managers will."

Contributors to the Hyperion portfolio this year include investments in healthcare manufacturer Fisher & Paykel Healthcare (ASX: FPH), ultra-sound medical device manufacturer Nanosonics Ltd (ASX: NAN) and software firm Technology One (ASX: TNE).

Outside of tech and healthcare, Macmillan says many small cap managers have ridden on the high price of iron ore, picking up mining and mining services companies. Those who bet on domestic agriculture stocks like Elders Ltd (ASX: ELD) have also done well.

Despite recent choppy performance, Macmillan says a key of Investors Mutual's competitive strength is the firm's steadfast adherence to its investment philosophy.

"They remain one of our favoured value style managers," he says. "But when you've been in a market where value has underperformed, it's difficult.

"Their focus on value, quality has stood the portfolio in good stead over the long term."

Morningstar's medallist small cap fund performance, FY20, 01/07/2019 - 30/06/2020

Source: Morningstar Direct

Growth's outperformance is not an Australia-only story. US growth-stock funds have emerged from the first half’s market turmoil with an even wider performance advantage over value strategies than they had at the start of 2020.

"Across one-, three-, five-, and 10-year time frames, and for large-, mid-, and small-cap stock funds, growth is outperforming value by the largest margin since the tech-stock bubble of 1999," says Morningstar data journalist Katherine Lynch.

"While value strategies have been left in the dust behind growth for years, the first-half 2020 underperformance is more striking in that value funds have historically tended to prove more buoyant in market downturns."

Markets periodic table | International markets

(Click to enlarge) Source: Morningstar Direct

Reporting season unknowns

As small cap managers head into August reporting season, Macmillan says three factors are weighing on their minds: how the federal government will use fiscal policy to stimulate the economy; the effect of stubbornly low interest rates; and how a possible nationwide second wave could affect consumer confidence and markets.

"Fund managers are weighing up all these factors, trying to forecast earnings over the next five years. This is a difficult task, especially when the outlook is so uncertain for many businesses to reopen" he says.

"I believe the numbers companies will report over the next six weeks won't be an important as their outlooks. Fund managers know it's going to be a very unusual 12 months ahead. They're looking to see which businesses are confident and which are cautious."

Macmillan is also looking to see how funds are managing their cash levels at a time when reserves are heightened.

"When the market is so volatile, small cap managers have to keep cash for opportunities," he says.

"Companies are also still undertaking equity raisings, which managers are keen to participate in.

"Generally, most small cap managers like to be fully vested. We're looking to see how they're balancing this risk with potential returns."

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