Home / Equities / The systematic, broad market advantage to be had in small-cap investing

The small-cap space can be rife with risk, as emotion and understanding wrestle with common sense practice. But with a systematic style overlaid to provide flexibility, diversification and liquidity, the benefits become clear.

As inflation loses steam and rates near the precipice of decline, the subsequent flow of capital into the investment market is set to bring small-caps back into play. This brings the bifurcation of small cap strategy into focus, in particular the inherent advantages of systematic investing over a more fundamental-style approach.

Small caps can be an emotional space, after all, as investors fall in and out of love with volatile companies that may or may not be the next big thing. But if the same systematic approach typically applied to large-cap investing is overlaid onto a small cap investment outlook, the emotion risk is mitigated and the benefits mount up.

According to global investment giant Invesco, systematic investing has better scope to outperform alternative methods in the small-cap space on a risk-adjusted and after-fee basis by employing quantitative models based on in-depth professional and academic research. Large sets of data ‘signals’, which are then grouped into ‘factors’, are then embedded into stock selection.

In contrast, a fundamental investor would typically conduct time-consuming and expensive onsite engagement with company management, supply chain player and customers.

While monitoring quality management and financial statements is a part of systematic investing, as well as sentiment and value indicators, it maintains a degree of agility that fundamental investment can’t match int he small-cap sphere.

“The openness to macroeconomic change allows systematic investors to capitalise on shifts in economic conditions and industries that fundamental manager might overlook,” Invesco explained in a recent whitepaper called Systematically Small. “By covering the entire investment universe and diversifying across all sectors, systematic investors can generate performance in different economic scenarios.”

That agility and ability to react is backed up by the superior diversification and liquidity investors gain from having a high breadth of assets.

“The wide range of individual stock positions and diversified exposure to industries and styles enable systematic investors to reduce concentration risk and trade out of positions with limited risk efficiently,” the whitepaper continues.

“Moreover, remaining true to the small-cap label ensures that systematic approaches provide investors with a distinct and complementary allocation to their core ASX100 holdings without unintended overlaps,” Invesco adds.

Not to be underestimated, too, are the cost advantages of employing a quantitative method.

“With the efficiency of rules-based approaches and shared research costs, systematic managers can offer investors lower fees while maintaining strong performance potential.”