The rise in passive investing has been a major theme of this market cycle. Data in the US suggest that passive funds now represent about 22 percent of the total US stock market; at least 25 percent of its trading volume; and broadly 40 percent of US equity-fund assets. Such a trend has been seen in both big and small company stocks, in the US and in many other countries too.
Given the strong historical performance of small companies (the MSCI AC World Small Cap Index has delivered a return of 384 percent since 2000), it is easy to see why investors are looking for profitable ways to invest in this sector. The attractions of simply buying stocks contained in the small-cap index are understandable. However, we need to consider a number of characteristics of this particular market.
Diluted returns, higher risk
One issue with passive investing in global small caps is that the breadth of the investment universe can provide too much diversification. With an index containing 6,000 stocks, representing 70 percent of the world’s publicly listed companies, the MSCI All Country World Small Cap Index is effectively a proxy for the global economy. An investment at the index level therefore lacks a clear focus.
Moreover, exposure to all the index’s companies, in all sectors, in all countries means that passive investors hold all the ‘losing’ stocks, as well as the ‘winners’. At the small-cap end of the market, there are more firms losing money, namely 17 percent of the companies in the global small-cap index compared with only 8 percent in the global large-cap index, according to a Bloomberg article at end-June.
The discrepancy is even larger if we compare the Russell 2000 Index of smaller companies in the US, where 31 percent of companies are loss-making, compared with only 6 percent of the S&P 500 Index. This large ‘tail’ of low-quality companies dilutes returns.
In addition, lower-quality companies tend to be more volatile. The higher proportion of these in small-cap indices raises volatility compared to large-cap equivalents. This might be tolerable for long-term investors who are prepared to weather ups and downs, but it can be painful during downturns. Indeed, this has created a perception among investors that small-cap investing is especially risky, when in fact it is mostly a function of the differences in index composition. The question for any investor is whether accepting this distortion means taking on unnecessary investment risk.
Focus on quality companies
Our investment process aims to exclude low-quality, risky companies and focus only on identifying higher-quality companies. The breadth of the global small-cap universe provides a range of countries and sectors in which to seek compelling opportunities. One example is Sunny Optical, a Hong Kong-listed company that makes camera modules and lenses for smartphones and vehicles. The company is benefiting from the transition to dual cameras on the back of smartphones, which give sharper pictures. It is also the world leader in vehicle lenses, with increased adoption likely in coming years due to legislation in Europe and the US, and the arrival of autonomous vehicles.
Another example is Teleperformance, a French company that is the global market leader in call-center operations, is gaining market share as more businesses outsource to specialist firms. The outsourcing trend has a long way to go, as 75 percent of call centers are still operated in-house according to a study by Everest Group, in our view providing ample room for growth.
There is a diverse range of investment opportunities to be found in the small-cap segment of the global equity market. When the above approach is implemented successfully, it can lower portfolio volatility, especially during market downturns, and increase returns. In the small-cap universe, higher risk does not necessarily equal high return, and our view is that it is often in the lower-risk companies that we can find the best long-term investments.
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