Small-cap Australian equity funds are showing surprising sustained strength in a difficult market, outperforming large-cap funds and other fund categories, according to Morningstar.
Australian equity mid/small blended funds returned an average14 per cent in the calendar year to 29 February, compared to 6.9 per cent from large-cap blended growth funds.
Over three years, the small-cap fund category returned 25.2 per cent annually, compared to 12.3 per cent for large-cap Australian equity funds that blend growth and value investment strategies.
Over 10 years, Australian small-cap equity funds returned 11.6 per cent annually, compared to 6 per cent for large-cap equity funds.
Standard & Poor's (S&P) SPIVA report showed more than 75 per cent of Australian small-cap funds beat the Small Ordinaries Index over five years, as at 30 June 2011.
Less than a third of Australian equity general funds outperformed the S&P/ASX 200 Accumulation Index over five years.
This outperformance of small-cap funds builds a powerful case to choose active over passive managers in this category.
Proponents of core/satellite investment strategies, which typically include lower-cost passive investments such as exchange-traded funds in the core and higher-cost active investments as satellites, might favour small-cap funds for active exposure over the long term.
Higher returns from small-cap equity funds also came with reasonable relative volatility.
Australian equity mid/small-cap blended funds had annual standard deviation of 16.5 per cent over three years, compared to 14 per cent for large-cap blended funds.
Higher risk in small-cap funds compared to large-cap funds was accompanied by much higher returns.
The solid performance of many small-cap funds is surprising, given the inherent volatility in this part of the market and the changing composition of the fund's key benchmark, the Small Ordinaries Index, because of the mining investment boom.
S&P data showed material and energy stocks now accounted for 44 per cent of the Small Ords, compared to 17 per cent in 2001.
The weighting of small financials in the Small Ords has slumped from 31 per cent to 8 per cent over a decade.
Many small-cap funds avoid riskier exploration stocks and get their resource exposure through mining service stocks and near-term producers.
There were fears the rising weighting of small-cap resource stocks in the Small Ords would make it harder for small-cap fund managers to outperform their benchmark.
The reverse also holds true; the underperformance of small resource stocks last year may have boosted managers that focus mostly on industrials, technology and financial stocks.
Small-cap funds have outperformed other Morningstar fund categories this calendar year despite fewer initial public offerings, discounted share placements, right issues or takeovers.
Capital raisings and floats can help small-cap managers, which get priority access to such offers, boost their fund's performance.
Fund managers have had to rely on astute stock-picking for performance, rather than on easy quick gains for company capital-management initiatives.
The most plausible answer for sustained small-cap funds' outperformance over large-cap funds is the price inefficiencies in the share market for stocks outside the top 300 by market capitalisation.
The lingering effects of the global financial crisis have prompted more sharebroking firms to reduce their coverage of small and mid-cap stocks, in turn creating more pricing and valuation anomalies for small-cap fund managers to exploit.
The Australian Securities Exchange recently announced it would subsidise some research on small-cap companies to improve liquidity at the market's lower end.
But with the economics of small-cap research waning for firms, there could be more valuation anomalies for small-cap fund managers to take advantage of in coming years, given many small and mid-cap stocks are poorly covered or not at all.
Even so, achieving high returns could get harder this year as the Australian economy slows, and small-cap companies, which generally have more domestic focus than large-cap companies, suffer.
Against that, a share market rally could see more interest in small-cap stocks, which are often among the first to rally when risk appetite lifts, as shown in the sharp rise in the Russell 2000 small-cap stock index in the United States this year.
