The (poor) case for indexing small caps

The debate on active vs passive continues to create headaches for many categories of active managers – particularly in highly competitive parts of the market such as large caps. In large caps, 80-90% of managers underperform their index on a 10-year horizon, and the index itself has become even lower cost to own, with Large Cap ASX200 ETFs available to retail investors at 4 basis points (0.04%).

As persistent as the difficulty has been for large cap managers to outperform low-cost indices, there has been persistence in the ability for small cap managers to outperform their benchmarks. This can be observed both here in Australia and globally. The most popular survey for comparing these funds is the S&P Index vs Active analysis – or SPIVA. As robust as their methodology is in general, we do observe two biases in their small cap survey that overstate how well indexed small caps do against active managers.

The two major biases in the survey are:

1) SPIVA compares small cap managers against the S&P / ASX Mid Small Index – which is a blend of small and midcaps. SPIVA take their active fund returns and categories from Morningstar. Active small cap funds are classified by Morningstar as Australia Fund Equity, Mid/Small (Value / Growth or Blend) – but the category benchmark applied to these funds by Morningstar is S&P/ASX Small Ordinaries index, not the S&P/ASX MidSmall index. This MidSmall index has outperformed the Small Ords Index by 2.9% per annum over the past 5 years, and by 3.8% per annum over the past over 10 years (to Dec 2022). MidSmall is probably not the most appropriate benchmark for the majority of the small cap funds they compare – although it would be for the few funds in the Australian Mid Cap category.

2) SPIVA compares net of fee small cap fund returns against an index without any fee applied. This may be fair enough when comparing large cap funds as an investor can access the benchmark (in this case the S&P / ASX 200 Index) for 4bps. The only two available small cap index funds (ETFs) benchmarked to the S&P/ASX Small Ordinaries Index charge 50bps and 55bps respectively.

SPIVA switched indices in 2011 or 2012, but in 2010 the last scorecard using the Small Ords Index showed only 29% of active small cap funds underperforming the benchmark over 5 years. The difference between the MidSmall index and a Small Ords ETF net of fees is 3.4% p.a over five years and 4.3% p.a over ten years. Correcting for these, we think 60-70% of active small cap funds would outperform the appropriate, net of ETF fee index.

Globally we also see consistent SPIVA results where active small cap managers do better than the index. The bias of small cap index ETF costs is consistent in all markets (UK, Japan, Canada, India cost between 50 and 74bps). The exception to both performance and fees is the US, where small cap managers struggle (89% underperforming over 10 years), and where you can buy a small cap index ETF for 6bps.

There are several reasons we believe active small cap managers can generate alpha in excess of their benchmarks in greater numbers than their large cap peers.

We have discussed these in detail before, but to summarise a few again:

Larger number of opportunities: Australian small cap investors are often choosing from hundreds, if not over 1,000 potential investment opportunities in their investible universe. Most large cap managers are limited to around 150 potential investments (the ASX 100 plus maybe 50 ex100 names).

A much more dynamic market: Using the Small Ords and ASX100 indices as examples, we can see the difference in dynamics between market segments. Around 40% of the Small Ords index (by weight) changes over most three-year periods. New IPOs, microcaps moving up, new industries emerging, large caps moving down, demergers and spin-outs. On the same metric, less than 10% of the ASX100 is new between most three-year periods. It is a much more static universe.

Fewer investors chasing each opportunity: Using fund manager surveys as an example, there are more large cap funds in the market (probably three times as many as small cap funds) and each large cap investment team tends to be 2-3 times as large. This means there are 6-10x as many investors analysing large caps as there are small caps.

Putting these together, in large caps you have a market which is smaller, which doesn’t change much and has a very large number of highly sophisticated, intelligent and motivated competitors chasing alpha. Not surprisingly a sustainable edge here is hard to find. Small caps are the opposite – a very large market of opportunities, which is always changing and has a much smaller number of investors competing for ideas. The difference in competitive intensity is more than an order of magnitude between them.

Other differences in the small cap market include:

Small cap life cycle: As we discussed last month, small caps have a much earlier life cycle than large caps, with many included in the index before they have proven their business models and unit economics in a commercially viable and sustainable way. This makes failure and extremely negative performance a more common feature in small caps.

Higher small cap skew: as previously discussed, small caps have greater skew than large caps, and the drag of losers on portfolio returns (per the life cycle point above) is exacerbated in this market. This can sometimes be underestimated by large cap investors fishing in the small cap pond.