Aussie ETF fail: Small Caps

Research shows that passive investing beats active investing. Smart investors are building portfolios that focus on asset allocation. Focusing their efforts of picking the right asset classes and sub-classes. Then using ETFs to power those portfolios.

Many investors we’ve spoken to start off with a template asset allocation from US financial literature. Something like the Coffeehouse Portfolio or William Bernstein’s Coward Portfolio. If you are an Aussie investor, that’s not much help to you. Especially because Aussie ETFs are failing when it comes to Small Caps allocation. With Small Caps making up 25% to 33% of these template portfolios’ growth allocation, there is a big chunk to think about.

Well, it’s not fair to say that ETFs are failing. The key problem is that passive investing in Small Caps doesn’t seem to work in Australia. US Small Caps fund managers are beaten by the US Small Cap Index (S&P SmallCap 600) around 80% of the time (after fees). Aussie Small Caps managers are beaten by the Aussie Small Cap Index (ASX Small Ordinaries) only 30% of the time.

 

Why are active Small Caps fund managers so effective?

One explanation to this difference is that the ASX Small Caps market is inefficient. This means ASX Small Caps companies are not always priced correctly. This provides smart investors with an opportunity to profit from superior knowledge, research, skills, etc.

Support this theory is that ASX Small Caps are small companies, therefore gets less attention / coverage. The average market cap of an ASX Small Ordinaries company is ~A$400m. The average market cap of a S&P SmallCap 600 company is A$1,200m. The larger the company, the more analyst cover it. This drives more interest, more trading and more efficient markets.

 

Would you invest in ASX Small Caps?

Based on the ASX Small Ordinaries performance, it certainly doesn’t make sense investing in Small Caps. Over the last 10 years, a $10,000 investment in the Small Ordinaries would be worth $10,819 now. The same investment in the ASX 300 would be worth $16,183.

Apart from returns, the Small Ordinaries (19.4%) was actually more risky (more volatile) than the ASX 300 (18.5%) as measured by standard deviation. CBA and Telstra aren’t called Blue Chips for nothing!

 

Active Investing

Of course, you can invest in Small Caps actively - picking stocks and timing the market. For example, investing through an active fund manager. In fact, there is a case for investing in active fund managers when it comes to ASX Small Caps. The chart below shows that over 5 years to June 2015, average return of active Small Cap fund managers (after fees) 10.2% per year. This is better than the ASX 200 of 9.7% per year.

 

What to do about it?

With the failure of Aussie Small Cap ETFs, it does leave Aussie investors in a bit of a pickle. You either allocate a portion of your portfolio in Small Caps to active management, or remove allocation to Small Caps all together.

This draws up another interesting point. Should passive investors invest in Aussie Small Caps at all? The ASX 300 includes around 200 companies falling within the definition of Small Caps - making up around 7% of the ASX 300. Should we waste 7% of our Aussie share allocation on a sub-asset class that don’t follow the conventional rules of active vs passive investing?

About the Author

jeremykl

Cofounder & CEO of BetterWealth (@jeremykwonglaw). Former investment banker turned technology entrepreneur. muru-D alumni (Telstra startup accelerator). Passionated about leveraging technology to provide better financial products & services to consumers. Coffee snob, business book reader, and fitness fan.

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