Joseph Mariathasan considers the resource demands inherent in making the compelling global small-cap opportunity manageable
There are few active managers running global small-cap portfolios on an active, fundamental basis. More typically, firms manage small-caps regionally, with US small-cap being the dominant strategy, accounting for 50% of global small-cap benchmarks.
This is not surprising, as gaining exposure to a global portfolio of smaller companies is not straightforward. The sheer number of names in the universe – there over 6,500 in the MSCI AC World Small-Cap index – their relative illiquidity, and the paucity of research, creates difficulties for both active and passive approaches to investment.
For active managers, the economics of supporting large research teams for a product line with limited capacity are difficult to rationalise.
“The sheer scale of the opportunity set – and some claim to consider tens of thousands of companies – creates many challenges in terms of design and execution of an effective and differentiated investment process,” says Eric Thielscher, senior research consultant at Cambridge Associates. “Team size, location, language skills, degree of quantitative input and travel are meaty considerations for such a niche product.”
Analysis requires at least the same and arguably more work per company as in large caps.
The high idiosyncratic risks require close monitoring and well-diversified portfolios, increasing the workload, whilst broker coverage has diminished since the financial crisis as investment banks have cut back on staff, increasing the requirement for in-house research. Active approaches, therefore, tend to be either highly-diversified and run using quantitative processes, or highly-concentrated and focused on fundamentals.
“Managers with highly concentrated portfolios have to be either incredibly skilful, or else incredibly lucky,” warns Young Chin, CIO for equity and alternatives at Pyramis Global Advisors.
Furthermore, a portfolio of 50-70 stocks can rapidly run out of capacity, with the manager effectively making a market in his own stocks; while client withdrawals can lead to forced selling of the most liquid names, adversely effecting remaining clients.
Going global can help ease these capacity problems. Managing a diversified global smaller companies strategy using traditional detailed fundamental analysis does offer the possibility of being able to exploit the inefficiencies in poorly researched, relatively illiquid markets, as well as exploit relative valuation differentials and other market inefficiencies. But global small cap portfolios of this type require a large commitment to staffing which only large multi-asset firms would be prepared to make, as they are able to exploit synergies between research in sectors and regions across a range of products. In any case, demand for global mandates has been mixed at best, says Thielscher.
“Numerous investors permit their favourite investment managers to invest using this broader opportunity set, but many others cite the challenges associated with ‘bucketing’ these crossborder mandates as an obstacle,” he points out.
Pyramis, Invesco and Allianz Global Investors are good examples of companies that have put in the resources to manage global small-cap portfolios using a fundamental approach. What they have in common is well-resourced teams, but they differ significantly in their approaches to tackling the complexities of managing globally.
One key issue is the role and location of small-cap analysts relative to the global portfolio manager. “Should they be near the portfolio managers, so they can interact with them continuously, or should they be on the ground giving local access to company management, often without translators?” Chin asks.
Allianz Global Investors made the decision three years ago to run what was their RCM global small-cap strategy as four regional strategies - North America, Europe, Asia and Japan, with no bets between the regions. The firm has around $14bn (€10.7bn) in small-caps, but most of that is in regional funds – only around $200m is in the global mandate, which is constructed by the regional fund managers selecting their highest-conviction stocks.
“In smaller companies, the management tend to be local,” says Andrew Neville, who heads this global strategy, overseeing the process and risk profile of the portfolio as a whole. “In Japan, for example, our analyst and fund managers speak Japanese.”
Pyramis, by contrast, runs an integrated small-cap strategy and has the scale to place analysts both centrally, in Boston, and locally.
“We have a dedicated global small-cap team who interact with research analysts, some from Pyramis and some from Fidelity, led by a single portfolio manager,” explains Chin.
“Within each sector, some sector analysts are based in Boston and some are around the globe.”
Pyramis’s objective – and challenge – is to build a single culture globally, and as Chin explains, there are a number of ways to address this, some subtle, some more obvious.
“For example, we don’t change the decor between our offices, so our associates feel comfortable in any of them,” he says. “We encourage our associates to move around, with typically 4-6 trips a year, lasting a week or two, to our other offices. If it feels like an event it is not enough: the idea is that staff are so familiar in another office that it is seen as nothing special.”
With 350-400 stocks in their global small-cap portfolio and an active fundamental process, Invesco is another example of a company that has committed substantial resources to this area.
“In Henley-on-Thames, we manage $100bn across all products, with small-cap accounting for just $1bn,” explains Nick Hamilton, head of global equity products, adding that this is up from just $300m five years ago. “But we don’t run our business on just the cold-hearted logic of numbers.”
Invesco has eight regionally-focused portfolio managers backed up by the firm’s large centralised research. The majority of the analysis is stock-specific, and the firm is also keen on small-cap broker research.
“Academic research has shown that forecasts by small-cap analysts are more accurate than those for large-caps,” says Hamilton. “The companies are simpler and the analysts have more passion. We are a big advocate of specialist brokers.”
Top-down macro asset allocations are clearly necessary for the global strategy given the independent regional managers (who also run regional portfolios). “We are currently only 30% weighted to the US versus a benchmark weight of 50%, with 30% in Europe versus a benchmark of 16% and 15% in Asia versus a benchmark of 2%,” Hamilton reveals.
Invesco also argues that an optimal global smaller company portfolio should capture both developed and emerging market opportunities. Traditional approaches to global smaller company investing have historically favoured developed markets, but incorporating investments in emerging markets can potentially enhance diversification and returns.
Emerging market exposures have typically come via large-cap focused global emerging market strategies. Yet extending beyond large-cap companies in these markets enables exposure to companies beyond the large, predominantly ex-state-owned emerging market corporates, many of which are required to undertake activities on behalf of the state, subordinating shareholder interests. The structural dynamics of consumption and industrialisation of the emerging economies can be accessed directly through smaller company exposure.
Managing global small-cap portfolios offers fund managers the ability to fish in possibly the most attractive universe of possibilities to generate outperformance and maximise the skills of their staff. For institutional investors, that should be an attraction hard to resist. The dilemma for fund managers is that small-cap management can never achieve the scale to match the income streams from large-cap strategies.