What is the best way to invest in Australian small caps?
The nature of Australia's stock market appears to have given active managers an edge.
At the end of December, I caught up with our market strategist Lochlan Halloway to discuss what drove equity market returns in 2024 and where Morningstar sees value going into 2025.
Lochlan identified two areas that looked cheaper than the market as a whole – stocks in the energy sector and companies outside the ASX’s biggest 20 names. As you can see in the chart below, these heavyweights had risen to a substantial premium to our Fair Value estimate by the end of November:
"A lot of smaller companies missed out on rally and now look a lot cheaper than Australia’s large caps” Lochie said in his recent Q1 outlook for Morningstar Investor members.
This got me thinking – what is the best way for investors to gain exposure to this slice of the market?
Investing in smaller companies has quirks. For one, individual investments in smaller companies may have a broader range of outcomes than ones in established, larger companies. There are few potential reasons for this.
First, far fewer smaller companies have established competitive advantages according to our analysts: less than 17% of companies in the index we use to measure Small/Mid Cap Australian equity fund performance have a Wide or Narrow Moat rating versus over 60% in the Large Cap equivalent.
This is skewed by us covering more of the larger companies, but I’d bet on it being directionally correct. Smaller companies may also not have a fully proven or optimised business model yet, and they may be more reliant on a single product line or a single country or industry for revenue.
With all of this in mind, a higher level of diversification might make sense if you are seeking exposure to smaller companies. This could be offset by having an intimate knowledge of every single position in the portfolio. But for most everyday investors that might not be feasible.
Just index it?
An easy reaction to cases like this might be to seek exposure through a low-cost index fund. But there’s a problem: passive exposure to Australian small-caps doesn’t have a great track record.
Morningstar’s Australia Small Cap index, for example, shows weaker performance than our Australia Large Cap index over much of the last 15 years, all while investing in companies that are potentially riskier due to some of the factors I outlined above.
Figure 2: Morningstar Australia index net returns as of December 31 2024. Source: Morningstar Direct
This might appear odd at first because in many developed equity markets, small-cap indices have traditionally delivered a higher return than large-caps over long time periods. This is widely referred to as the “small cap effect” and is often explained by investors being compensated for extra risk.
The US is a notable exception here because large-cap stocks (especially the big tech names) have done very well for several years now. In many markets, though, the “small cap effect” still seems to pop up when you look at returns over 15 years.
Figure 3: 15 year (annualised) small and large cap benchmark returns as of December. Source: Morningstar Direct
Why does the Aussie smalls index underperform?
One popular explanation for the weaker relative performance of Australia’s small-cap index is that is dominated by mining upstarts. As the theory goes, a lot of these companies are highly speculative and many of them fall towards zero, dragging on the average return.
I can’t definitively prove that today. But it’s hard to argue that Australia’s small-cap index isn’t dominated by mining plays. Here is how our Australia Small Cap index’s weighting to Metals & Mining compares to other countries and regions:
Figure 4: Index weightings to Metals & Mining stocks on January 21 2025. Source: Morningstar Direct
Australia’s large-cap benchmark is also skewed towards miners (they make up around 18% of Morningstar’s Australia Large Caps index) but those miners have become large-caps for a good reason. They have proven assets, many of which are of world-leading quality, and far less likely to be worth zero.
Canada is another developed market where mining stocks make up an outsized percentage of smaller shares. Morningstar’s Canada Small Cap index had a 22.2% weighting to Metals & Mining as of the end of December. And guess what? Its small-cap index has also lagged the large-cap benchmark.
When you are looking at data across countries like this, there is always a risk that any similarities are circumstantial. One thing is for sure, though: if you own a small-cap index fund in Australia, mining small caps are going to have a big impact on the results you get.
Enter active funds?
This brings about a situation where active small-cap managers may be well placed to add value for investors in Australia. This appears to be supported by the average returns achieved by managed funds in our Mid/Small Cap Australian Equity category.
The table below, taken from Morningstar’s most recent semi-annual review of active versus passive funds, shows that the average fund in our Australia Mid/Small Blend category has done very well against the average passive fund over three, five and ten year periods.
For reasons we have already discussed, beating the Aussie small cap index might not be that tough a hurdle, though. So I also compared the average return of funds in this category to the return achieved by Morningstar’s Australia Large Cap index.
Figure 6: Australia Mid/Small Blend category versus large-cap index. Source: Morningstar
The average Mid/Small fund has lagged the large cap index over the past five years but has beaten it handily over both ten and fifteen years.
So perhaps a small-cap effect does exist in Australia after all. Once active managers come in and, generally speaking, cut the skew to mining stocks significantly.
Figure 7: Australia Mid/Small Blend Category versus Index sector weights as of December 31 2024. Source: Morningstar.
A special case?
The success of Australian small-cap managers versus the category benchmark stands heads and shoulders above that of their peers in the US and Europe.
Figure 8: Small Cap fund success rates. Source: Morningstar Active/Passive Barometer.
All considered, it seems that active funds in Australian small-caps have more potential to reward the faith of investors than in many other stock markets. Even after you account for the higher fees you’ll often see here compared to passive funds.
Investors still need to tread carefully and be selective, though.
For one, it is vital that you are clear on what fee structure is attached to the product you are considering. At the time of writing, the vast majority of funds in our Small and Mid Cap Australia category charge a performance fee.
This means that in many cases, you will give back around 20% of any outperformance over the benchmark – a bogie that we have already seen might not be that hard to beat. These fees will be paid on top of your standard annual management charge.
You should also seek funds with an investment philosophy and proven process that you are comfortable sticking with for the long-term (think five to seven years plus for small-cap equities). You can read more about finding your investment philosophy here.
