Home / Equities / The active advantage in small cap investing explained

The rise of passive investment makes tremendous sense, especially when the index being tracked is on the large cap side. Move down the index, however, and it can pay to have someone sorting out the winners from the losers.

No one could debate the recent dominance of passive investment, with exchange traded funds (of which 90 per cent are passively managed) riding a decade-long bull run on the back of increasingly concentrated markets.

In Australia, the biggest companies in the country, predominantly miners and banks, take outsized positions in the index, with success largely breeding success for our biggest companies, and the market tracker products that follow them rewarding investors doing so.

For large cap active equity investors, explained Invesco director of factor investing & multi-asset strategies Scott Bennett on a recent RASK podcast, it’s been a tough era to demonstrate value because the market itself is so robust that identifying undervalued companies is problematic.

“Large cap indexes are designed to represent the entire market and the best the insights of the collective wisdom of everyone, so that effectively means successful companies get rewarded with increasing weight in those indices, while poorly performing companies get a lower weight and ultimately get relegated out of those indices,” Bennett said. “And that makes a lot of sense. Those indices are really hard to beat because they’re effectively weighted towards success and away from failure.”

But that dynamic is flipped on its head in the small cap sector, which has a far broader opportunity set for active managers than the large cap sector.

With small caps, Bennett explained, the sector isn’t necessarily built purely on success. The are companies on their way up, and there are companies on their way down from the large cap sector. Buy the index, and you’re buying a proportion of both the winners and the losers.

Employ the expertise of an active manager to help identify the winners and avoid the losers, however, and the dynamic changes dramatically because the “mechanics” aren’t the same.

“With large caps, you’re effectively importing success because companies that are doing well get brought into the index, and the failing ones get exported,” he said. “For small caps, it works the other way around. So as companies start doing well and getting bigger, they actually get exported out and kicked into a large cap index. So your success effectively sees you exit the index, and then also you’re importing those companies that used to be large and now becoming small. So what you find is that passive works [for] large caps because you’re effectively weighted towards success.

“Within small cap indices you’re actually weighted towards two things,” Bennett continued. “One is failure, and the other one is hope. That presents significant opportunities for active management within small caps, and we would definitely advocate anyone considering an exposure to small companies, especially within Australia, to do that actively, because otherwise you’re effectively building a portfolio that’s weighted towards failure and hope.”

By proactively sorting the companies on the way up from those on the way down, Bennett explained, active management can be much more impactful in the small cap arena than it can in large caps. The results make a compelling argument, he said, with the average annualised excess return (over the benchmark) for the median Australian small cap manager at 5.9 per cent.

“There’s no other market in the world where active managers as a whole are generating that level of excess return,” he said.