Investors unwilling to explore the growth potential of small-cap stocks because they are worried by higher volatility may be missing out, according to Kepler Trust Intelligence’s William Sobczak.
The investment trust analyst said research by the firm suggests that the extent of volatility in small-caps might have been overstated.
He said: “Popular wisdom has it that over the long term small-caps have outperformed large-caps, but this has tended to be at the cost of greater levels of volatility.
“In fact, the last five years have seen lower volatility from small-cap stocks relative to large-caps across the world.”
Possible explanations for the lower-than-expected volatility, said the analyst, might include the extended bull run in markets or the extraordinary level of support for markets from central banks – such as quantitative easing and low interest rates – since the global financial crisis.
As an example, Sobczak said over the past five years the FTSE Small Cap index has registered a lower maximum drawdown than the FTSE 100 while delivering a higher total return with comparable volatility as the blue-chip index.
“When comparing small-caps to their large-cap peers, the stronger performance stands out across most geographies,” said the analyst.
Performance of indices over 5yrs to last month-end
Source: FE Analytics
In Europe, the MSCI Europe Small Cap index has delivered almost double the total return of the MSCI Europe with lower volatility.
“This combination of superior returns and comparable volatility is an attractive blend,” said the analyst.
There is one exception, however, in the US where the strong performance of FAANG (Facebook, Amazon.com, Apple, Netflix and Google-parent Alphabet) stocks has favoured the mega-cap S&P 500 index.
While companies at the smaller end of the market scale have generally outperformed their large-cap peers, managers in the space have also been able to add greater levels of alpha.
Indeed, the ability of fund managers to generate alpha can be seen in the outperformance of the average fund and trust of the index in the below chart.
Performance of sectors vs index over 5yrs
Source: FE Analytics
The average IT UK Smaller Companies has generated a total return of 58.48 per cent over five years, while the average open-ended IA fund is up by 79.65 per cent. In comparison, the FTSE UK Small Cap index has returned 54.77 per cent.
Sobczak said the ability to generate alpha could be attributed to the less efficient nature of the market and the scarcity of information on smaller companies.
“In a perfectly efficient market, prices reflect all available relevant information at any time and share prices will then always accurately echo a company's fundamental value,” said the analyst.
“Conversely, where information is scarce, prices do not always reflect this value – allowing investors to exploit this inefficiency to generate alpha.”
Traditionally, it has not been economically viable for brokers to cover the small-cap space unless it has been paid for by the company itself.
This feature of the small-cap space has come into focus more recently following recent regulatory changes such as the implementation of Mifid II – the second iteration of the Markets in Financial Instruments Directive – which requires fund managers in Europe to pay for research previously provided free of charge.
Another reason for the outperformance of small-cap strategies, said Sobczak, could be their relative insulation from macroeconomic themes.
“This was seen earlier this year in the US when small-cap stocks raced ahead of large caps with the talk of trade wars,” he explained.
“Small-caps were perceived as a ‘safety play’ due to their absence of exposure to overseas markets, where US multinationals may have found their products additionally taxed or suffering other retaliation due to trade disputes.”
The Kepler analyst also noted that small-cap stocks are more likely to be affected by stock-specific issues than larger companies, highlighting again the importance attached to detailed research of smaller companies.
Further, small-cap stocks are likely to be less correlated to each other than their larger peers, according to Sobczak.
While individual small-caps might be more volatile than larger companies when combined in a portfolio that volatility is reduced, he noted.
As the below chart shows, the FTSE 100 has exhibited higher rolling one-year volatility than the average sector funds over the past five years with the exception of a post-Brexit referendum spike.
Rolling 12-month volatility over 5yrs
Source: FE Analytics
Another issue facing large-cap stocks that might have contributed to higher volatility is the incredible rise of passive investing in recent years.
“Over the past few years we have continued to see unceasing inflows into exchange-traded funds and other passive forms of investment,” said the analyst.
“These vehicles focus predominantly on large-caps and, as such, greatly impact on large-cap stock prices.
“It is conceivable that at the margin, diversification between large-cap stocks has decreased as a result of this 'blind' buying by passives.”
Small-caps, he added, are rarely included in these passive strategies, limiting the impact of substantial flows into the space.