Smaller companies funds have been a safer place for investors to hide than their large-cap peers, according to the latest study from FE Trustnet.
In the next in its study of the Investment Association sectors’ upside and downside capture ratios, FE Trustnet looks at why small-cap sectors in Europe, Japan and the UK all held up better over the last decade when global equities are falling.
Indeed, the best place to have been is the IA Japan Smaller Companies sector, which captures just three quarters of the losses of the MSCI AC World.
Upside/downside capture of sectors relative to MSCI AC World over 10yrs to end of October
Source: FE Analytics
George Lagarias, senior economist at Mazars Financial Planning, said there is a cyclical reason behind the outperformance.
“I have noticed that large caps during periods of bull markets and low volatility tend to outperform but only in the end of the cycle,” he said.
“As you reach the end of the cycle the large caps have outperformed so it is time for the small caps to outperform again.
“I ran a quick study on this recently and it was just for the S&P 500 and the Russell 1000 index but I found that the large cap in a period of below average volatility – in 1996, 1997 before the crash and also in 2006-7.”
He added that large-cap stocks have been outperforming their small-cap peers for the last three years, signalling that the current market cycle is maturing.
Simon Evan-Cook senior investment manager at Premier Asset Management, noted that liquidity could be a factor.
When global equities begin to fall large caps are often the first companies to be sold as they are easier to move in and out of, according to Evan-Cook.
He said: “Away from the crisis periods, there may also be a liquidity effect. In minor corrections, large caps can often take the hit as investors initially sell what they can but in a more severe bear market, small caps can catch up and are often hit even harder.
“This is something investors would do well to remember if they’re expecting defensive attributes from a small-cap investment.”
However, more likely to be the main reason is the larger weighting to banks, miners and oil stocks in the large-cap indices.
While some active managers will avoid these sectors altogether, others such as value investors will own them and the passive vehicles in the IA sectors have no choice but to own the index weighting.
“Japanese and UK large-cap indices have large exposures to big banks, whereas the small-cap indices have lower weightings to this sector,” he said.
“Clearly this has been a very volatile part of the market to have been invested in over the last 10 years. Additionally, in respect of the UK, small caps have a lower weighting to miners and oil companies, which has been another source of steep downside volatility.”
Rob Morgan, pension and investment analyst at Charles Stanley Direct, agreed with Evan-Cook that the absence of banks has been a benefit for smaller companies in Europe and the UK.
Indeed, banks have significantly underperformed over the last 10 years, with the FTSE World - Banks index 106.72 percentage points below the broader FTSE World index.
Performance of indices over 10yrs to end of October
Source: FE Analytics
“It is, however, still a counterintuitive result because many people would expect small caps to be more geared to the health of the economy,” Morgan said.
“Perhaps therefore it essentially shows that with small caps there is more esoteric risk rather than market risk, and the dynamic nature and growth prospects of smaller companies can actually overcome other factors given sufficient time.
“It does back up what certain fund managers have said to me over the years that while large businesses are traditionally seen as safer there is often significant risk involved and they find better opportunities further down the market cap spectrum.”
In terms of Japan, he said that smaller companies’ ability to shelter from investors is to be expected as the large-cap indices are dominated by large exporting companies whose prospect tend to be dependent on the health of the global economy and the strength of the yen.
“The two are linked: If the global economy weakens the yen tends to strengthen due to its ‘safe haven’ status resulting in a double headwind for these firms. Thus domestic Japanese companies (which would include many of the small caps) actually tends to hold up better in this scenario,” he said.
However, as mentioned above there is one outlying asset class – the IA North American Smaller Companies and IA North America sectors.
Mazar’s Lagarius noted this is because the US dollar is seen as a defensive, safe haven for investors in falling markets.
“In asset allocation terms everything you have is a binary choice – should I be invested in America or not? Should I own the dollar or another currency?,” he said.
“The question then is during difficult times would you put your money in the world’s reserve currency or in another currency? You would go for the world’s reserve currency.”
From an asset allocation point of view, Premier’s Evan-Cook noted that the large-cap index is much more diversified than the others, with less in banks and miners and a much higher exposure to huge, global tech companies.
“These have been the decade’s big winners, and would have given US large-cap indices a level of downside protection that was missing in its small-cap funds and other developed markets,” he said.
Indeed, as the below chart shows, the S&P 500 index has been the best performing of the major indices over the last decade.
Performance of indices over 10yrs to end of October
Source: FE Analytics
Charles Stanley’s Morgan added that the high technology weighting has skewed the results.
“Small cap has less exposure to this top performing area, plus large-cap tech (Amazon, Facebook, Google etc.) has shown phenomenal growth and has overall done better than small-cap tech too.”