Key Insights
- Australian investors’ propensity to allocate capital into domestic small caps is much greater than global small caps. This is despite the evidence for a superior ‘small cap effect’ in the global equity markets.
- Global small caps have a number of unique attributes that appear structural in nature, and importantly, offer longer term diversification benefits for Australian investors within a global equity portfolio.
Introduction
The ‘small cap effect’ - where small capitalisation companies (with a market cap of US$500 million to US$5 billion) outperform the large capitalisation companies over time - is a widely accepted anomaly in global capital markets.
In their seminal paper, Professors Fama and French concluded the out-performance of small caps over large caps (i.e. the ‘small cap effect’) was due to an element of risk that is unique to small caps. In other words, investors are compensated for undertaking additional risk when investing in companies with a relatively small market capitalisation. Other empirical studies have also demonstrated that smaller companies have higher rate of earnings growth than large caps.
In the most recent decade, the ‘small cap effect’ has been strongly evident in the global equity markets. Importantly, the presence of the ‘small cap effect’ is not the result of just one or two outlier years of out-performance.
For example, in the last 10 years and on a rolling one-year basis, global small caps outperformed global large caps 60 percent of the time. Over three and five-year rolling periods, global small caps outperformed global large caps 74 percent and 89 percent of the time, respectively.
Despite the high certainty of global small caps outperforming global large caps over three to five year periods, Australian investors have been reluctant to allocate capital outside the global large caps and global emerging markets within their equities portfolio.
An allocation to global small caps can:
- substantially increase the investment opportunity set and potential for adding alpha,
- complete the 'capitalisation range’ of an international portfolio,
- provide demonstrated added diversification benefits, and
- offer relative valuation advantage over large caps.
