Summary
In the ongoing debate between active and passive management, many still believe that there is greater opportunity for fund managers to add value when investing in companies with smaller market capitalisations. While the evidence indicates that, as a group, active managers in the small cap category have been able to outperform the index, individual managers have failed to maintain their level of outperformance over time. Investors, therefore, should not select fund managers on the basis of reputation and historical performance alone but should also base their decision on an informed view of the manager’s ability to maintain that performance into the future.
In this article we examine the performance of ten of the most highly rated small cap fund managers in Australia to determine the lessons for fund selection.
Why Small Caps
Many investors believe that the market for smaller companies offers the greatest opportunity for long-term wealth creation. The primary reason is that this small cap market is much less efficient at pricing shares because of the limited analyst and investor coverage. In contrast with large companies that are closely analysed by a broad range of fund managers and broking analysts, small companies don’t have sufficient market capitalisation to warrant interest from institutional investors managing large amounts of money. This creates an information asymmetry and opportunity for investors willing to do the research that will give them a competitive advantage when it comes to assessing the fundamental value of small companies.
As seen from the evidence presented in our previous analysis of fund manager performance, small to mid cap fund managers have been able to outperform the market over five and ten year horizons.
Fund Manager Performance
The key question for investors is how to find the right small cap fund manager. In order to help answer this question, we have examined the performance of the ten most highly rated small cap managed funds at the end of 2015 as assessed by Morningstar analysts (a leading investment research group). As evident from the graph below, this group of managers was able to outperform the ASX 300 index fund by 3.4% p.a. over the 5 year period ending in 2016.
Investors in these managers at the beginning of 2012 would have clearly achieved superior returns to investing in an index fund. The problem, however, for newer investors is that the strong performance to the end of 2015 ended abruptly in 2016 with the group of fund managers underperforming the index by 7.6% in that year.
Why did this happen and what does it mean for investors selecting a fund manager on the basis of reputation and track record?
Investment Strategy
One of the reasons for the large deviations in performance of the small cap managers was their focussed investment strategies. Most of these manager have investment strategies that exclude exposure to the resources sector. Their strong performance in 2015 was, therefore, at least partially attributable to not holding resource stocks as prices tumbled. Unfortunately most also missed the subsequent rally in the resource sector, contributing to underperformance in 2016.
The chart above clearly demonstrates that the small cap managers have outperformed when resource stocks have performed poorly and underperformed as resource stocks have rallied. This alone, however, does not fully account for the deviations in fund manager performance in those years.
Herding and Trending
Our examination of the data for the ten fund managers indicates a high degree of overlap in their stock selections. The following table depicts the overlap between managers for the most commonly held stocks in their portfolios.
‘Trending’ is one of adverse consequence of managers following similar investment strategies. It occurs when the weight of money flowing into the market finds its way into the best performing funds and stocks, which then further inflates market prices for these stocks. There was clear evidence of this phenomenon occurring over 2015 and 2016 with many of the fund managers holding high profile stocks such as Blackmores, Domino’s Pizza and Vocus Communications amongst their top 10 positions. The stock prices for these ‘market darlings’ rose significantly in 2015 before falling back to earth in 2016 as they could no longer keep up with the weight of expectation built into their share prices.
Lack of Persistence
When it comes to sustaining performance over time, small cap fund managers demonstrate a lack of persistence similar to general equity managers. As demonstrated by the S&P analysis below, only one of the 24 small cap managers rated in the top quartile in 2012 was able to sustain that level of performance over the following five years.
The specific reasons for this lack of persistence are most likely due to the same factors that cause many fund managers to underperform. Apart from the role of chance in historical outperformance (even a randomly selected portfolio of shares has a 50% chance of outperforming the index) there are several well documented reasons as to why active managers underperform. As we describe in our white paper on the Perils of Indexing, the three most important factors which detract from performance are:
Asset bloat, where fund performance decreases as the fund size increases, as funds reach sizes where managers can no longer just trade in just their ‘best ideas’
Closet indexing, where fund performance decreases the closer a fund tracks its benchmark index, as funds react to their investor’s desire to avoid short-term underperformance of the index
Low conviction, where fund managers dilute their performance by diversifying their fund portfolio with a number of low-conviction companies with low portfolio weight
Small cap managers are by no means immune to these factors and are particularly exposed to asset bloat as their growth in funds limits their opportunity to generate material value add from the smaller cap stocks. Many of the leading fund managers have grown their fund size to several hundred million dollars and in some cases over one billion dollars, limiting their investment universe to medium size companies where mis-pricing opportunities are less prevalent.
Implications for investors
The evidence presented above supports our view that fund managers cannot be selected solely on the basis of past performance and reputation. Although these findings can be equally applied to large cap equities, the problems in the small cap space can be more acute due to the greater volatility of returns.
Unfortunately there is no simple answer to picking the right small cap manager. The investor must seek to understand the factors driving historical performance and take an informed view of the manager’s ability to deliver outperformance into the future.
Investors should also seek to have a portfolio of fund managers with different investment strategies and less correlated returns. That way investors can periodically rebalance their portfolio to manage their risk exposure based on prevailing market conditions.
While we prefer direct exposure to small cap stocks in order to access opportunities that fall under-the-radar of the institutional investment community, we have also identified high quality small cap fund managers of a suitable size to invest in this sector.
Disclaimer
This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future performance.