The role of global small and mid caps in an Australian portfolio

Australian investors understand the case for including domestic small and mid cap (SMID) companies in their portfolios and have typically benefited from these allocations. This is however, at odds with their more sparing allocations to global SMID, leaving them underweight this non-trivial USD $13 trillion asset class (approximately 40x the size of the Australian SMID market).

Whilst it is understandable from a behavioural perspective that investors naturally gravitate toward large and well-known foreign companies when investing offshore, Fairlight believes that there is a compelling case for also including an allocation to Global SMID for several key reasons:

Global small outperforms global large

Long-term studies provide a wealth of evidence to support the claim that globally, smaller companies outperform their larger counterparts. From 1927 through 2015 in the U.S., the return premium earnt by investing in small cap companies relative to large cap companies was 3.3% (Andrew Berkin, 2016). Similarly, an analysis of fifteen European markets found an average return premium of 2.4% to small companies over the period 1982-2014 (Stanley Black, 2015).

The small company return premium is intuitive as smaller companies are able to grow faster and have a longer runway to compound growth. Less sell-side coverage means that smaller companies exhibit greater mispricing offering further opportunities to outperform. The return premium may also be compensative for lower liquidity and less diversified business models.

The probability of small company outperformance increases steadily with investor time horizon. Figure 1 shows that for long-term investors, the probability of small company outperformance has historically approached 100%.

Figure 1. Source: Hanna & Peng, “Small Stocks vs Large: It’s How Long You Hold That Counts”, 1999

An allocation to SMID improves the risk/return characteristics of global equities

Diversification is famously the one free lunch in finance and investors can benefit from the imperfect correlation of small and large caps. The reason for this imperfect correlation is because returns generated by large cap stocks are substantially driven by common global factors, while in contrast, returns from small cap stocks are primarily driven by local and idiosyncratic factors.

Whilst small companies are modestly more volatile than large ones in isolation, a blend of global large and global small companies does not necessarily have to be more volatile than a portfolio of global large companies because of the benefits of diversification (Figure 2 uses a large/SMID ratio of 75/25%). This allows investors to earn some of the historic return premium associated with smaller companies, without necessarily taking on additional risk. Restated in finance theory terms - the addition of global SMID moves the efficient frontier of the portfolio upwards.

Figure 2. Source: MSCI & Fairlight (MSCI data series begins Feb 2002)

The absolute risk characteristics of global SMID are attractive relative to Australian equities

The ultimate barometer of the risk characteristics of an asset class was the realised performance during the 2008 financial crisis. During this difficult period, global SMID exhibited better risk control for unhedged Australian investors than both Australian large cap and Australian small cap equities (see Figure 3). This relative defensiveness comes from the tendency of the Australian dollar to depreciate relative to other developed world currencies in periods of economic stress, providing a buffer to unhedged AUD returns.

Figure 3. Source: MSCI

For Australian investors adding a portfolio allocation to global SMID can increase portfolio expected returns without commensurate increase in risk. The Fairlight Global Small and Mid Cap Fund provides exposure to a portfolio of 30-40 high-quality global SMID companies selected with valuation discipline.