Global small caps are supposed to be more volatile than their large-cap cousins. But do the positives of an expansive investment universe and greater agility outweigh the negatives?
According to Ben Sheehan, senior investment specialist – Equities at Aberdeen Standard Investments (ASI), global small caps represent 70 per cent of the available equities in the marketplace. And by not allocating to them – either due to their perceived volatility or the ‘crowding effect’ of large-cap performance – investors are missing out.
“Over the very long term, there’s strong evidence of small caps outperforming large caps,” Mr Sheehan told Investor Daily.
“We’ve got data going back to the 1930s in the US, the 1950s in Europe, and the 1970s in Japan which shows that, in the overwhelming majority of markets, small caps have actually outperformed the market.”
And despite the belief that small caps are a riskier investment due to the volatility that comes with higher illiquidity and credit risk, the truth is more complex.
“Small caps, as a rule, are marginally more volatile than large caps,” Mr Sheehan said.
“But it’s worth contrasting that with other asset classes – small caps are actually less volatile than European equities or emerging market equities. So on a relative basis, the volatility isn’t as high as many people would think.”
But discerning stock selection is critical. And there are plenty of companies in the small cap space that are small for a reason.
“They might not be the best run, or have a bad track record, or they have very high levels of leverage,” Mr Sheehan said.
“These are the companies we will actively avoid.”
ASI uses quantitative screens – scouring the entire market for companies that rank positively on balance sheet and earnings growth – and qualitative analysis, which involve meeting with management and conducting detailed, bottom-up research on the company.
Of course, while their size makes them more agile than their large-cap cousins, it also means that small caps can suffer more during periods of market distress. But if investors look through the short-term risk, there’s plenty of reward to be found.
“History has indicated that they do tend to recover, and recover well, over the long term,” Mr Sheehan said.
“They are a part of the market that needs more attention.”