Beyond beta: Harnessing the potential of Australian small companies

Over the past few decades, investors have enjoyed strong returns across various asset classes, driven by factors such as central bank support, globalisation, low inflation, and declining interest rates. At the same time, the growth of passive investing has channelled capital into large, highly liquid stocks. Looking ahead, predicting macroeconomic trends remains inherently difficult. As markets continue to evolve, this adds a layer of uncertainty regarding the potential to achieve comparable levels of capital growth, notably in real return terms, in the future. While large cap equities have historically driven growth for investor portfolios, future opportunities may lie in less traditional areas—such as Australian small caps. Often overlooked, this segment has delivered strong long-term performance, especially through skilled active management.

This article explores the compelling return profile of Australian small caps, the structural advantages that support sustained alpha generation, and why this segment warrants a consideration for dedicated allocation in a forward-looking equity portfolio.

The evolving investment landscape and the need to re-evaluate return drivers

In recent decades, most asset classes have delivered strong absolute returns, largely supported by the forces of globalisation—which have helped keep inflation low—and accommodative central bank policies, especially the sustained decline in global interest rates. These favourable conditions have propelled asset prices upward, leading to valuations that, in many instances, now exceed historical averages.

While we do not seek to forecast macroeconomic trends, central bank policy, or future equity performance, there is increasing concern that markets continue to evolve relative to historical trends. Within this backdrop, achieving the historically high levels of capital appreciation observed in previous cycles could prove significantly more difficult, at least in real return terms.

Considering ongoing market evolution, investors are increasingly challenged to evaluate whether their current strategies remain aligned with long-term financial goals. Historically, large cap equities—both domestic and global—have been central to generating portfolio growth. However, a critical question now emerges: can all segments of the equity market continue to offer the same growth potential? Importantly, not all equity markets possess equal capacity to generate capital appreciation. As a result, investors are progressively turning toward more differentiated sources of return and alpha, moving beyond traditional beta-driven exposures.

One segment that continues to stand out is Australian small caps. Since the early 2000s, actively managed Australian small cap strategies have delivered superior capital appreciation, consistently outperforming both the S&P/ASX 200 Index and the median Australian large cap equity manager. Remarkably, this outperformance has occurred even as the broader small cap benchmark (S&P/ASX Small Ordinaries Index) lagged, highlighting the effectiveness of active management in uncovering opportunities within this less efficient and often overlooked segment of the market.

Cumulative total return (starting index = 100) of the benchmark and median manager for both Australian large caps and Australian small caps, respectively

Source: Morningstar, FactSet, Maple-Brown Abbott. Past performance is not a reliable indicator of future performance. Performance figures between 28 April 2000 to 30 June 2025. The chart assumes starting base of 100.

Diversification advantages through sector breadth and idiosyncratic opportunities

Compared to the heavily concentrated Australian large cap market – dominated by financials – the small cap segment offers more balanced industry representation and greater exposure to emerging, high-growth sectors. For instance, the S&P/ASX 200 Index is heavily weighted towards financials, particularly due to the prominence of the Big Four banks. In contrast, small caps have a stronger representation of the Information Technology sector, offering investors access to evolving growth trends that are often under-represented in large cap portfolios.

Sector weights for Australian large caps and Australian small caps

S&P/ASX Small Ordinaries Index

Source: Maple-Brown Abbott, FactSet, figures as at 30 June 2025.

Whilst small caps have a higher overall exposure to resources – including both materials and energy – they offer significantly more diversified opportunities within the sector. Unlike large-cap resource companies, which are heavily concentrated in bulk commodities such as iron ore and coal, small cap resource companies provide broader commodity exposure, operate across more diverse geographic regions, and frequently engage in early-stage projects. These projects are often aligned with long-term structural megatrends, including the global energy transition, demand for battery metals, the rise of uranium, and the growth of the electric vehicle supply chain. Notably, gold represents the largest single exposure within Australian small cap resources. This is underpinned by strong and sustained demand from central banks, as well as increasing interest from institutional and retail investors, reflecting gold’s enduring role as a safe-haven asset and a strategic hedge against economic uncertainty.

Underlying commodity exposures across the Australian large cap and small cap resource indices

Source: Maple-Brown Abbott, FactSet, ‘Large Caps’ and ‘Small Caps’ refers to S&P/ASX 100 Index and S&P/ASX Small Ordinaries Index, respectively, 2025.

Another key differentiator is the idiosyncratic nature of Australian small cap equities. The growing prevalence of passive and quantitative investment strategies has contributed to a significant concentration of capital in large cap stocks. Since the introduction of Superannuation performance tests, investment in passive index-tracking vehicles – such as ETFs – has nearly doubled. Furthermore, the proportion of the S&P/ASX 200 Index share registry attributed to investors employing passive investment strategies has risen from 16% in 2015 to 26% in 2025. This trend may accelerate further, particularly following the increase in the Superannuation Guarantee levy to 12% as of 1 July.

A clear beneficiary of this passive shift is the Commonwealth Bank of Australia (CBA), with a market capitalisation exceeding $300 billion as of 30 June 2025. Notably, CBA represented 13.1% of the S&P/ASX 100 Index at that time – an increase from 10.6% in June 2015.

In contrast:

• The top 10 stocks in the S&P/ASX Small Ordinaries Index carry a similar combined index weight to CBA alone in the S&ASX 100 Index, respectively.
• The top 30 small cap companies in the S&P/ASX Small Ordinaries Index collectively represent a lower cumulative index weight than the top five large cap stocks in the S&P/ASX 100 Index – three of which are major banks.

This disparity underscores the diversification advantage offered by small caps, as their index composition is less concentrated and more evenly distributed across a broader range of companies.

Stock weights for Australian large caps and Australian small caps

S&P/ASX 100 Index

S&P/ASX Small Ordinaries Index

Source: Maple-Brown Abbott, FactSet, figures as at 30 June 2025.

Unlocking superior earnings growth through innovation

Australian small cap companies frequently serve as early-stage access points to high-growth segments that are not yet fully recognised by the broader market. Many of Australia’s most successful companies—including Altium, REA Group, Pro Medicus, Technology One, and Afterpay – originated within the small cap universe.

Key drivers of superior earnings growth among small caps include their greater exposure to emerging structural and thematic growth trends, higher operating leverage stemming from lower base revenue and cost structures, and their ability to capture market share in fragmented industries, even during economic downturns. There is a strong correlation between medium-term earnings growth and share price performance, placing Australian small caps in a favourable position relative to other equity classes.

One of the last untapped sources of market inefficiency

As global markets become more efficient – driven by data transparency, improved disclosure, and algorithmic trading – the opportunity for active managers to generate alpha has narrowed significantly, especially in large cap equities. This is most evident in U.S. large caps, where active managers have struggled to consistently outperform the benchmark.

Percentage of US large cap equity funds outperforming the S&P 500 Index each year

Source: Maple-Brown Abbott, S&P Global, S&P Dow Jones Indices LLC, CRSP, 31 December 2024.

However, Australian small caps stand out as an exception. The median active Australian small cap manager has outperformed both the small cap benchmark and large cap peers over long-time horizons. The consistent outperformance of Australian small cap managers can largely be attributed to the high degree of market inefficiency that characterises this segment. Lower levels of sell-side research coverage, limited institutional ownership, and reduced market scrutiny create an environment where stock prices are more sensitive to company-specific news and earnings announcements. Additionally, quantitative factors such as price momentum, earnings revisions, and quality metrics tend to have a more pronounced impact on performance. These inefficiencies present skilled active managers with meaningful opportunities to identify and capitalise on pricing anomalies, resulting in the potential for significant alpha generation over time.

The persistence of alpha generation in this segment is well-documented, affirming its viability as a strategic allocation within diversified portfolios.

Rolling 3-year median Australian small cap and large cap manager active returns

Source: Maple-Brown Abbott, FactSet, monthly data between May 2000 – June 2025, Morningstar Australian small cap and large cap manager universe vs. S&P/ASX Small Ordinaries (Total Return) Index and S&P/ASX 200 (Total Return) Index, respectively.

Looking ahead, two factors are likely to preserve – or even amplify – market inefficiencies in Australian small caps:

1. Global Irrelevance: The entire S&P/ASX Small Ordinaries Index has a market capitalisation roughly 1/20th that of NVIDIA, attracting little offshore institutional capital.
2. Passive Crowding: The continued growth of passive investing channels capital to large cap names, increasing price dislocations at the smaller end of the market and creating liquidity for exit opportunities as small caps graduate into major indices.

Harnessing emerging thematic trends

Australia’s equity market is heavily skewed toward mature, oligopolistic industries, including banks, supermarkets, and insurers. However, small caps provide access to the next generation of growth via exposure to under-represented or emerging sectors, including:

• Technology and Innovation: AI, cloud computing, digital health, clean energy, and automation.
• Structural Growth Trends: Digital transformation, aging demographics, and scalable software-as-a-service (SaaS) platforms.
• Niche Markets: Unique product or geographic exposure offering high-margin and defensible business models.

An example is the Buy-Now-Pay-Later (BNPL) sector, which emerged from the small cap universe before achieving global scale.

Maturing quality and improved fundamentals

While historically more volatile, the quality of Australian small cap companies has improved significantly in recent years. This evolution is marked by a notable shift away from resource exposures, which have declined from 45% in 2010 to approximately 30% today. Additionally, there has been a rise in the number of capital-light and profitable businesses, particularly within the Information Technology sector. Gearing metrics have also improved, accompanied by more stable and predictable earnings profiles, contributing to the overall enhancement in quality across the small cap segment.

Australian small cap market profitability and gearing metrics

% of Australian small cap companies that are profitable

Median gearing level (%) and cash ($ millions) metrics

Source: Maple-Brown Abbott, FactSet.

Building portfolios with Australian small caps: Unlocking growth and diversification

The appropriate allocation to Australian small caps within a broader Australian equity portfolio will vary based on an investor’s objectives and risk tolerance. However, historical analysis suggests that:

• A 20%–30% allocation to an actively managed Australian small cap strategy can enhance portfolio returns,
• This allocation can be achieved without materially increasing overall volatility or correlation to the broader market (S&P/ASX 200 Index).

Return vs. risk characteristics based on different small cap manager allocations as % of a typical Australian equities portfolio

Source: Maple-Brown Abbott, FactSet, Morningstar, median large cap manager and median small cap manager data based on Morningstar manager universe data between 30 April 2000 – 30 June 2025. Past performance is not a reliable indicator of future performance.

Return vs. risk characteristics based on different small cap manager allocations as % of a typical Australian equities portfolio

Source: Maple-Brown Abbott, FactSet, Morningstar, median large cap manager and median small cap manager data based on Morningstar manager universe data between 30 April 2000 and 30 June 2025. Past performance is not a reliable indicator of future performance.

The bottom line: Why Australian small caps should be considered for strategic allocation

As the market environment evolves, traditional sources of capital appreciation may struggle to deliver the outsized gains investors expect. In this context, Australian small caps present a compelling opportunity, offering strong long-term returns, superior earnings growth, and meaningful diversification.

Active Australian small cap managers have historically outperformed both large caps and benchmarks, benefiting from structural inefficiencies that foster alpha generation. This segment provides access to diverse sectors and emerging growth industries often absent from the large cap universe, including early exposure to innovative business models and transformative themes.

Improved quality and profitability have made small caps more robust and investable. When included in an actively managed portfolio, small caps have enhanced returns without significantly increasing volatility. In an environment where alpha is scarce, Australian small caps remain one of the few inefficient market segments, offering growth, innovation, and diversification to help investors meet long-term goals.