After five years of strong collective outperformance, 71 per cent of active small-cap funds underperformed their benchmark index in the last quarter of 2010, the latest Standard & Poor's SPIVA scorecard shows.
This may be an aberration, but the mining boom is clearly making it harder for small-cap funds to outperform.
The main index against which small-cap funds are measured, the S&P/ASX Small Ordinaries, has a rising weighting in resource stocks.
In 2001, materials and energy stocks accounted for 17 per cent of the index and financials 30.6 per cent, S&P data shows. By 2011, materials and energy stocks accounted for 48 per cent and financials 9.94 per cent.
Many mining and energy stocks in the Small Ords, which measures stocks ranked 101 to 300 by market capitalisation, are still in the exploration phase and yet to make a profit.
They are typically too risky for small-cap funds that get their leverage to the resources boom through profitable mining services companies, mining producers or explorers nearing production.
Excluding speculative exploration stocks from small-cap funds has long-term merit. After last year's share price boom, the resources component of the Small Ords now trades on a forward price/earnings (P/E) ratio of about 18 times, compared with a long-term average of 13.3 times.
Small-cap industrials trade on a forward P/E of about 12 times compared with a 10-year average of 14.7 times.
Small-cap funds are in a difficult position: including speculative explorers adds more risk to their portfolio; excluding them risks falling behind a benchmark index that increasingly includes more exploration stocks.
Fund managers might argue that index weightings are misleading, because industrials and financials easily dominate the Small Ords when companies are weighted by profit. And top small-cap funds have shown they can outperform in all market conditions.
In the five years to December 2010, 71 per cent of Australian equity small-cap funds beat the Small Ords, S&P's SPIVA report show. The sector's five-year annualised return of 7.99 per cent compares with 5.54 per cent for the index.
Small-cap funds have easily outperformed large-cap funds, which returned 3.75 per cent on average annually over five years to December 2010, compared with 4.32 per cent for the S&P/ASX 200 Accumulation Index, S&P data shows.
More than 60 per cent of active Australian funds failed to beat their respective benchmarks over five years, S&P found, which shows just how well small-cap funds have performed, and why there has been a strong argument for active exposure to small-cap stocks over index exposure.
But no outperformance lasts forever. S&P data shows the Small Ords index outperformed just 29 per cent of small-cap active funds over five years. Over three years, the figure is 31.5 per cent, and 44.2 per cent over one year. In the December quarter it was 71.23 per cent.
One quarter of collective underperformance by small-cap funds is hardly the end of the world, nor a trend, although S&P data shows the Small Ords index is catching up with more small-cap funds, partly because of the mining boom and the widening share-price performance gap between small resource and industrial shares.
Morningstar data shows that small-cap stocks were the best-performed listed asset class in 2003, 2006, 2007 and 2009. Investors might wonder whether small-caps can collectively outperform other sectors after such a strong run.
Small-caps typically lead market recoveries and have more relative exposure to the Australian economy than large-cap companies with a higher proportion of earnings from offshore operations.
Small-cap exposure worked a treat when Australia was the best-performing economy among developed nations. But they now trade at parity with blue-chip stocks (based on average forward price/earnings multiples for the Small Ords and S&P/ASX 200 indices), even though they deserve to trade at a discount, given small companies generally have less-established franchises and less management depth than top 100-companies.
This analysis suggests investors should review their small-cap exposure, and managers' outperformance could be more difficult over the next few years.
The good news is Australia has plenty of excellent small-cap managers who have shown they can consistently outperform over long periods.
The sector deserves the benefit of the doubt for now, but investors would be wise to watch whether it has collective quarters of under-performance.
