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Investing In Small & Mid-Cap Equities: Northern exposure

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The state pension fund AP4 is one of Sweden’s most enthusiastic investors in domestic equities. Its CEO, Mats Andersson is not only convinced that the domestic equity market in general offers better returns over time than the rest of the world, largely due to the Swedish governance model, he also notes that small Swedish companies also have performed better than large ones. 

“We are the last home-biased fund in Sweden,” says Andersson. “We also have about 15% of our Swedish equity portfolio invested in small-caps, which is a lot. Many investors shy away from small-caps because of low liquidity and high volatility but our long-term horizon means that we are very well suited for investing in this segment.” 

He believes part of the reason others keep a much lower small-cap allocation is short-term performance evaluation; AP4 evaluates the investments over at least a three-year period. Other reasons include liquidity and solvency requirements. 

“That means we can pick up a premium that others, for various reasons, are unable or unwilling to get exposure to,” Andersson says. 

While AP4 manages most of its domestic small-cap portfolio internally, it also invests in a small-cap and a micro-cap fund, and has seeded an engagement fund. 

Johan Ståhl, manager of Lannebo Fonder’s Swedish small-cap fund, says that when it comes to the investment case for Swedish small-caps, the numbers speak for themselves.

While the Swedish stock market over time has performed better than the MSCI World, Swedish small-caps have further outperformed large-caps by a significant margin. The average aggregate return to Swedish equity funds over the past 10 years has been around 170%, according to Morningstar but, as an example, Lannebo’s small-cap fund has had aggregated a return of more than 300%. AP4’s small and mid-cap portfolio returned 42.6% in 2013 and 12.1% for the first six months of 2014. 

Ståhl says that the Swedish history as an export nation has rubbed off onto its smaller companies.

“Many of the Swedish small-cap companies are global – I think that’s pretty unusual,” says Ståhl. “It doesn’t hurt that the companies are based in Sweden, which is one of the stronger European economies. But I usually preach that by investing in Swedish small-caps it’s not Sweden or the Nordics that you get exposure to – it’s a truly global exposure.”

SPK, the Swedish pension fund for banking sector employees, overhauled its investment strategy over the past year, and Swedish small-caps now make up about 5% of its total assets. 

Stefan Ros, SPK’s CIO, says that this was both a way to increase the risk profile of its equity portfolio and to improve the alpha-generating potential. 

“We still have a 30% allocation to Swedish equities but the result of our ALM analysis showed that we could increase the equity risk in the portfolio. As a result, we decided to add a Swedish small-cap mandate,” says Ros. “We’ve noted that if you look at Swedish equity managers in general, it appears that they have some difficulties generating alpha, while the possibilities to do that appear better within small caps. In a more challenging investment environment, we believe that this could become very important.” 

SPK picked Handelsbanken because of the manager’s careful approach to active risk. 

“Without mentioning any names, for some managers it appears to be more about the gut feeling rather than a structured process,” says Ros. 

SPK does not rule out the possibility of adding further small-cap mandates. Peter Hansson, SPK’s CEO, says: “We’ve started with Swedish small-caps but we will keep on adjusting the portfolio and this could result in adding some global small-caps.”

Swedish life company Skandia Liv, however, has gone in the opposite direction and no longer has a specific Swedish small-cap allocation. Until a few years ago, it had two separate three-person internal teams for large-caps and small-caps, but the teams are now integrated and small-caps are part of the general Swedish equities allocation.  

Hans Sterte, Skandia Liv’s CIO, says: “There are times when small-caps perform better than large-caps but we expect our portfolio managers to take care of this. You don’t need a specific small-cap mandate and the more you divide things up and put up restrictions, the more difficult it becomes to move around.” 

Sterte adds that it also was a way to become more cost-efficient as the small-cap contribution of returns was limited compared with the resources required for a dedicated mandate. 

“Since the small-cap team was working with a much smaller universe, its relative contribution to the total alpha was very small, so it was rather costly compared to large-caps,” Sterte says. 

Recent months have been a reminder of the volatility of small-caps. Swedish small-caps had a significant dip during autumn of 2014, only to make a quick recovery. But, as Ståhl points out, company earnings are much more stable than the stock market prices. Andersson adds: “I think volatility is a bad measurement of risk. For us, having a permanent loss is a risk but it’s not a risk for us if market valuations go up and down.” 

Ståhl also emphasises the need of having a long-term view. 

“The greatest risk is having too short a horizon for the investments,” he says. “Things will move up and down depending on the general risk mood. But the companies don’t get better or worse depending on, for example, what the Fed says. And that volatility also creates opportunities.”

 

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