There are two reasons why European institutional investors might consider investing in global small cap stocks. First, both theory and evidence suggest that they offer higher potential returns. Second they provide powerful diversification benefits.
The challenge to date has been to design and manage a credible product that can provide exposure to all the main theatres of small cap investment – the US, Europe and Asia-Pacific. Philip Nash, director of London-based Dimensional Fund Advisors Ltd, the European arm of US-based Dimensional suggests that this has held back the development of global small caps as an asset class:
“The market place has been saying to us that there is significant demand for global small cap exposure. At the same time investment consultants have told us that, although they like the idea of a global small cap asset class, their research has tended to indicate that the expertise of small cap managers was region-specific. They can manage Asia or Europe or the US but they cannot manage them all.”
Dimensional, whose approach is quantitative, has now launched a Dublin-based collective investment scheme carrying the UCITS passport which it says will provide the necessary global reach. It is structured as an umbrella fund – Dimensional Funds plc, with three sub-funds: US Small Cap, European Small Cap and Pacific Basin Small Cap.
“Part of the reason that we wanted to offer these regional modules is that, depending on where you are in the world, foreign small cap will mean different things. The three regional sub-funds enable us to give modular exposure to investors from a variety of domiciles and base currencies.”
The funds will, over time, include a proportion of micro cap companies, defined by Dimensional as the bottom 5% of listed companies. Dimensional’s global small cap universe comprises between 8% and 10% of the listed market. “The market has a very long tail with the micro cap segment covering a lot of very small companies right at the bottom of the market”, says Nash. “The beauty about micro caps is that they have more pronounced characteristics than small caps generally. They have an even better diversification effect upon a portfolio and even higher expected returns. So the investor is getting a very pure size factor exposure.”
Small cap shares are illiquid and trades can be costly. Dimensional therefore trades its small caps through patient regular trades or through block purchases where sellers give Dimensional a price discount in exchange for liquidity.
“We are seen as a provider of liquidity at the bottom of the market,” says Nash. “Where sellers have a significant position that they are trying to sell, we can often be more accommodating than most smallcap managers because our portfolios so broadly diversified that we are prepared to purchase a very wide range of names. We’re looking to purchase any blocks at a discount to reflect the liquidity we are offering to sellers and this obviously contributes to our fund performance.”
Investors can choose to invest in one, two or all three of the Dimensional Funds plc sub-fund. If clients want a global small cap exposure, Dimensional will manage the regional allocation for them or they can manage it themselves.
“If you take the market capitalisation weights, the US market weight is over 50%. For some investors that may be too much, so they might want to bring that down to 40% or perhaps even 30%. Typically, European investors will say to us they’d like to have 40% or 50% in Europe and maybe 30% or 35% in the US,” says Nash.
The three sub-funds were launched early this year. “We’ve gathered over $50m of assets in the launch period and hope to grow this significantly this year,” says Nash.
One of the main planks of Dimensional’s investment philosophy is the conviction that value companies have higher expected returns than growth companies, and that this rule applies at least as much in the small cap as in large cap. Furthermore Dimensional believes that the ‘class’ premia available from small and value stocks are more reliable sources of incremental return than those available from stockpicking.
Consequently, Dimensional plans to add small cap value funds to its umbrella at some point in the future in order to give combined exposure to these two sources of expected higher return.