Including small caps in portfolios requires a different approach in Australian equities than it does in international equities. But a thoughtful approach can add significant alpha, Mine Super’s Susan Chau says.
The premium derived from small-capitalisation stocks, also known as the size effect, is one of the best-known premia in equity investing and one of the few premia that is widely accepted in academia.
University of Chicago alumnus Rolf Banz is likely to have been the first to describe the size effect in his 1981 paper, “The relationship between return and market value of common stocks”, and his concept was further developed by Nobel prize winners Eugene Fama and Kenneth French in their three-factor, and later five-factor, model.
But the small-cap premium can be somewhat elusive in the Australian market. As a group, small caps haven’t been able to outperform large caps on a risk-adjusted basis for many years, Susan Chau, Head of Equities & Responsible Investment at Mine Super, has found.
“I did a piece of research a few years ago which showed that over the last 20 years or more, Aussie small caps haven’t outperformed large caps. There is this general assumption that the higher growth expected from small caps is eventually going to deliver and outperform. But it actually hasn’t been the case,” Chau says in an interview with [i3] Insights.
There is this general assumption that the higher growth expected from small cap is eventually going to deliver and outperform. But it actually hasn't been the case [in Australian equities]
Part of the reason for the underperformance of the small-cap index in Australia is that the sector includes a relatively large number of non-revenue-generating, speculative mining companies, while the index is also dragged down by former mid-cap companies that have faced hard times and fallen out of the mid-cap index.
But where the small caps as a group fail to outperform, active small-cap managers tend to add significant alpha compared to the small-cap benchmark.
“The average active, small-cap manager has generated good alpha in that space. That is the part that we want to capture,” Chau says.
“We moved a component of the [Australian equity portfolio] to passive in 2018 and we constrained that to be passive just the top 100 stocks, the ASX 100. And then we complemented that with fully active, small-cap managers.
“This way, we constrain any unintended small-cap beta overweight because it aligns with the thesis that small-cap beta does not outperform over time, but we do want to capture the alpha from that part of the market. Having that construction has really helped us perform well in the last couple of years because small caps have really underperformed, except for the last few months. And, of course, we can still choose to take a tilt if we have a shorter-term view of small caps.”
Having a passive exposure to the 100 largest Australian stocks, complemented by active, small-cap mandates, helps the fund avoid too much small-cap beta exposure. This is because the ASX 200 and 300 indices include many small caps and a passive exposure to these indices would have resulted in a significant drag at times of small-cap underperformance if combined with dedicated small-cap mandates.
“We haven’t had that type of [small-cap overweight] exposure and our managers have been performing really well,” Chau says.
She says the fund has been able to get access to good small-cap managers as some of Australia’s largest super funds had to abandon their active, small-cap mandates due to capacity constraints.
“A lot of the larger funds have been internalising or winding back their small-cap exposure because they just can’t get the capacity or they are moving up the market cap spectrum and have expanded their mandates to include mid-caps,” she says.
“And because of that, we were able to access a really, really strong small-cap manager that was closed for at least a decade.”
The overall portfolio construction of the Australian equities sector is also complemented by a small selection of good, high-conviction broad-cap managers where the manager is able to pick stocks across the full market-cap spectrum.
International Equities
But where Australian small caps as a group underperform large caps, the same is not true for international equities. The small-cap premium is clearly visible not only among US stocks, but also in global stock markets.
“In developed markets, the research shows that it’s actually quite the opposite to small caps in Australia because in global equities over time, small caps have outperformed large caps,” Chau says.
In developed markets, the research shows that it's actually quite the opposite to small caps in Australia, because in global equities over time small caps have outperformed large caps
“So for that reason we have intentionally taken a small-cap tilt in our developed market sector and we do that through a global small-cap and US micro-cap allocation.”
High-conviction strategies like these is where the fund spends much of its risk budget versus the Your Future, Your Super benchmarks, as these strategies attract a relatively high tracking error, she says.
“We’re talking about tracking errors of 8 per cent plus, so the active risk is quite high, but that’s why we anchor the overall risk down by the passive exposure we have,” she says.
The Barbell Approach
Having a passive exposure to large-cap equities to offset the tracking error of high-conviction strategies is commonly known as a barbell approach.
Historically, many funds have built their strategies based on large, active core allocations to equities, but Mine Super found these core strategies increasingly struggled to produce alpha over the benchmark.
“Many years ago, we used to have a very large allocation to core active equity managers, so around the 2 per cent tracking error range. And we found that over time, it was increasingly harder to generate consistent alpha in that space,” Chau says.
“We saw this in Aussie equities, but particularly even more so in global equities, because the US market is such a big part of the MSCI World Index and it’s so efficient that if you look at the median manager, alpha generation has deteriorated over time.
“So what we did was take a lot of those core exposures and put them into passive.
Many years ago, we used to have a very large allocation to core active equity managers, so around the 2 per cent tracking error range. And we found that over time, it was increasingly harder to generate consistent alpha in that space
“What we have had in place since 2018-19 is a barbell approach. So we have a reasonable allocation to low-cost passive and we barbell that with very high-conviction managers or strategies that are more niche and where alpha is relatively easier to generate.
“Apart from US micro-caps and global small caps, we also have a deep value and a very high-growth allocation in our broad-cap strategies.”
Having a large passive anchor also has helped the fund navigate the outperformance of the Magnificent Seven.
“Active managers have generally had such a hard time recently because if you want a diversified portfolio, then generally you just can’t have enough of the Magnificent Seven to be able to perform well,” Chau says.
“Although we still have a slightly underweight position in the Magnificent Seven by nature of our deep-value and small-cap allocations, having a passive anchor has actually helped because that’s how we’ve been getting a lot of that Magnificent Seven exposure.
“Overall, there has been enough alpha to offset some of those structural underweights to the Magnificent Seven.”
Emerging Markets
Mine Super splits out its international equity exposure into developed and emerging markets (EM). The EM part of the portfolio is managed in a fully active way, since the countries that make up this sector have very different economic and return profiles.
Some of these markets also have governance issues that require a more hands-on approach, Chau says.
China is a key exposure in EM and Mine Super’s allocation to the country has evolved over time. When the Your Future, Your Super legislation came into force, the fund was initially caught out by a significant underexposure to the country as its active managers had a structural underweight to the market either with no exposure or a large underweight exposure.
“We had a large underweight to China just by the nature of our managers’ style and preferences. We had a quality bias in EM and because of Your Future, Your Super that presented a very large tracking-error problem for us, particularly years ago when China really rallied hard,” Chau says.
We've never taken a big bet on China in terms of an active allocation-type position, that's why we had a completion strategy. You'd have to be quite brave to take a big bet in that market, particularly with the outcome of the US election
“So we took a completion strategy to close that tracking-error gap. But over the last few years, what has happened is that China sold off with concerns over their property market, government policies, geopolitical risks and the trade war, notwithstanding the more recent bounce because of stimulus.
“The valuations of the market became really low and we saw some of our incumbent managers actually become more constructive in the Chinese market with increased exposure, so we removed the completion strategy. We didn’t need it anymore.”
Mine Super has moved from marginally overweight China to now marginally underweight. But Chau is quick to point out this is a result of the managers’ investment decisions, rather than the team’s view on China.
“We’ve never taken a big bet on China in terms of an active allocation-type position, that’s why we had a completion strategy. You’d have to be quite brave to take a big bet in that market, particularly with the outcome of the US election. The uncertainty is even greater with potential tariffs and the likely continued geopolitical risks,” she says.
“So notwithstanding the bounce in the Chinese market after the stimulus, we are not unhappy with the current position.”
Negotiating Fees
Mine Super is currently in the process of merging with TWUSUPER and has recently launched its revamped investment menu, including a simplified default life-cycle option. The merger has also provided an opportunity to review the existing mandates and determine if there is room for improvement in terms of fee structures.
Chau is looking to reduce the merged fund’s overall fees with the greater use of tier structures, where fee levels reduce as the fund allocates more money to a particular manager.
“We’re condensing the number of managers and it means that with fewer managers we can tap into better tiering arrangements with larger mandates. The incentive is the more we invest with a manager, the less we pay in terms of a basis-point fee on those allocations. And, of course, if you have too many managers, you don’t get to move down the tiering scale,” she says.
“In addition to our incumbent managers, we were also able to negotiate with new managers who we are onboarding, some which had a fixed rate, to put them onto a tiered rate as well. And in some cases, there might have already been tiering in place, but then it’s about renegotiating the rate at each tier.”
Where there are investments in unit trust investments, typically due to lower allocations, the merger has provided the opportunity to transition some of these exposures into dedicated mandates.
“There are a number of smaller investments that might have had less flexibility in fee negotiations, but now with greater scale, we can potentially convert those into mandates if appropriate, giving us more flexibility in investment parameters and fees,” Chau says.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.