Living a life of their own
First, an uncomfortable truth. Few European pension funds are likely to have much room in their portfolios for US small caps, defined as US companies with a market capitalisation of between $200m (E178m) and $1bn. The average asset allocation to all US equities by European institutional investors is around 20%. Since small caps account for no more than 10% of US equities, funds are unlikely to invest more than 2% in them as a separate asset class.
That said, some of Europe’s larger pension funds are showing a growing interest in US small caps. And where the leading pension finds go, others are likely to follow. Most recently AP3, the Third Swedish National Pension Fund, with SKr120bn (E13.16 bn) under management, appointed Axa Rosenberg Investment Management to manage $190m of its US small and mid cap equities portfolios.
The mandate was part of AP3’s long-term strategy of portfolio diversification to generate the maximum returns for the fund. Jennie Patterson, global sales, marketing and client service director at Axa Rosenberg IM in London, says that diversification is the main reason why European pension funds are focusing on US small caps within their equity portfolios. “Once European pension funds get to a certain size they look to diversify away from just a broad market index. So instead of having one US or Japanese or Pacific ex-Japan portfolio they will split it between a large cap and a small cap. Funds look to diversify away from just pure large cap because obviously the returns of small cap aren’t very closely correlated with large cap. In fact, over the last three-year period they’ve done considerably better than large cap.”
Separating the management of US small caps from US equities makes sense, says Robert Siddles, head of US small caps at F&C Management in London. “The US equities market is a huge universe, roughly 3,000 public companies between $100m and $3bn which probably makes it the biggest pool of public equities in the world.
“If a US small cap mandate is lumped in with a large cap mandate its difficult for investment managers to get exposure to the area as part of a general US equities portfolio. They would need to hold a large number of shares and administratively for the pension fund that might look odd.”
It also makes it difficult for pension fund boards or trustees to review the performance of small caps within a US equities fund. “Tracking errors are much higher when investing in smaller companies. For example tracking errors currently for our US small cap portfolios are currently about 10%. They’d be substantially lower for US large caps – in the order of 3%.”
However, the strongest argument is that small caps behave differently from large caps since they have different investment cycles In the bear markets of the past three years small companies have strongly outperformed large caps. Since the end of 1999 to the end of August this year, the most widely used small cap index, the Russell 2000 fell roughly 1.5%, while the S & P 500 fell 31.4%.
Once a pension fund has decided that it needs to diversify into US small caps, the next decision is a choice of benchmark. Funds have a choice of US small caps indices, principally those provided by Frank Russell, Standard & Poor’s and Wilshire.
The two key requirements are that an index must be investable and it must be compatible with the investment style – core, value or growth – that the pension fund has chosen.
Preston Athey, US smaller companies portfolio manager at T Rowe Price (TRP) in Baltimore and president of TRP’s small cap value fund, says the Russell 2000 satisfies both these conditions; “The Russell 2000 is not only considered a good index for small caps but it is considered a workable index. Technically an institution could buy any share in the index and be assured of being able to buy a modest position in a reasonable period of time.”
One feature of the index is that it is rebalanced each June strictly according to market cap principles. Companies that have risen to mid cap status leave the index, as do companies that have fallen to micro cap status. Plus any new companies that appear in the small cap universe. This means that it will always include the lowest 2000 of the top 3000 US stocks
This distinguishes the Russell 2000 from its nearest rival, the S&P 600, where re-balancing is decided by a committee. This also has its advantages, says Athey. “The S & P 600 is an index that doesn’t change much, unlike the Russell 2000 that might undergo 20% turnover in any one year. So from an institutional standpoint, if one were to benchmark a manager to the S & P 600 it would not engender potentially a fair amount of turnover for no reason.
“Another advantage of the S&P 600 is that the companies that enter the index are institutional grade. That is, they are fairly widely owned by managers. They have very good trading volume and they are more easily bought and certainly better known to the average manager.”
The choice of investment style will be dictated by the size of the mandate. Although Russell separates its core US small cap index into value and growth sub-indices, it is unlikely that most European pension funds would award mandates large enough to justify hiring value and growth manager.
Most pension funds are likely to choose a blend of the two styles managed either by a core manager able to tilt as necessary into value or growth, or with a slight bias to value. Axa Rosenberg IM, for example, says it positions itself as a core manager with a bias to value, says Patterson. “We basically look for stocks that have a longer-term earnings advantage relative to the markets, so therefore we’re buying cheap stocks and that would bring in a slight value bias. We also look for stocks that have short-term earnings growth advantages as well which mitigates the value bias.
“But we would be thought of more as a core than as a value manager because we have exposure to all the sectors, whereas a true value manager would only invest in certain sectors of the market.”
Investment managers like Frank Russell that take a multi-manager approach to US small cap investment offer the closest to a blended approach. Erik Ogard, portfolio manager responsible for all Russell’s US small cap portfolios says: “Our approach is very style-neutral. We target the style weightings of the underling index in our construction of the funds so that we match the various style weights in the indexes. We rebalance continuously to these in what we call dynamic re-balancing, using our client flows to stay on target to the underlying index growth/value weight.”
Re-balancing ensures that Russell stays close to the weights of each style since there should be no expected return from being value or growth, he says: “Our view is that security selection in either source can add value. Really we’re after a stock selection advantage and anything else, any deviation, is really just a source of tracking error without an expected return.”
This flies in the face of the idea, floated by Eugene Fama and Kenneth French in the 1990s, that not only were small companies likely to outperform large companies but value was likely to outperform growth. This proposition was picked up by Rex Sinquefield and David Booth, founders of Dimensional Fund Advisors .
Booth says the reason for the better returns from small caps is that small stocks and “financially challenged” companies have higher costs of capital than large cap stocks and financially healthy companies. “The basis for our investment strategies is that big safe companies do not have to offer as great a return to investors as small more speculative companies. Your investment return is the flip side of the company’s cost of capital. The return you get is the return the company foregoes when it issues the stock.”
Individual small cap value managers have their own reasons for their style bias, but all are convinced that they can outperform growth. Robert Perkins of Perkins, Wolf, McDonnell & Co who manages the Janus (formerly Berger) Small-Cap Value fund, says most studies have shown that over the long term value investing wins out, chiefly because it buys at the bottom of the market. “The market is like a pendulum. It overacts both on the plus and on the minus side, and the over-reactions are more dramatic in the small cap area than the large cap area. We try to take advantage of those swings and buy when the pendulum is swinging towards the downside.”
This has the double of advantage of removing most of the risk – because the company has lost as much as it is going to lose – and providing a reasonable reward. “If you can determine that whatever has caused the stock to be down is a temporary problem and can be fixed in a reasonable length of time, you come up with a very favourable risk reward equation,” he says.
The broad benchmark data gives weight to the belief that value wins over growth. Returns from the Russell 2000 small cap value and growth indices show that value has outperformed growth over the 24 year history of the index.
However, individual portfolio managers have found that reality does not always square with theory. Preston Athey of TRP says that in practice it is more difficult to generate alpha with value small caps than with growth small caps: “Active value small cap managers outperform their index less frequently and with a smaller amount than active growth stock investors outperform their index. That may not be intuitive, but the net result is that one is equally well served by being in either a value or growth style.
Athey suggests that one reason for this is the higher trading cost of value small caps. “The bid-ask spreads are much wider for value stocks and liquidity is much worse. So if you’re running a large sum of money it takes much longer to get in and get out of a position. Another reason is the greater inefficiency of the growth small cap market. “In the growth world, the active managers make extraordinarily good use of information. They are more likely to be trading against the uninformed investor who may not have access to the same analyses or information. So the institutional manager appears to be able to take advantage of disequilibria in the market from a growth perspective more than he can as a value manager.”
The choice of investment style will determine not only the nature of the stocks to be held but the number. US small caps thrive on market inefficiencies that lead to the mispricing of securities. But to spot these mispricings, the portfolio manager has to track and analyse companies constantly. How many companies can a manager reasonably manage?
The answer largely depends on the sort of investment manager a pension fund decides to appoint. On the one hand there is a manager like Dimensional that takes a more passive approach than most traditioanal managers. Dimensional will build a portfolio of almost 3,000 securities for its US small cap fund. Philip Nash, director of the European arm of DFA in London, explains: “What we try to do as a first step in the process is to look at the US small cap asset class and see if we can create an asset class from all the available small companies that will give us a better portfolio than the Russell 2000 or any other conventional benchmark.”
Dimensional’s current US small caps portfolio, for example, begins with an initial universe of around 5,000 stocks. Dimensional then strips out anything that it feels does not qualify as an investable small cap. These include REITs, foreign stocks, and closed-end investment companies. This leaves an eligible universe of around 3,500 stocks. Dimensional then takes a closer look and removes any stocks that have pricing concerns (IPOs and bankruptcies) trading concerns (fewer than four market makers, or a limited trading history) and other miscellaneous worries such as inadequate data. This results in a final potential buy list of between 2,500 and 3,000 stocks.
Another way of covering a large universe of stocks is to employ quant techniques. Axa Rosenberg IM, for example, receives data from external sources about 17,500 companies worldwide, 6,000 in the US. Axa Rosenberg’s Patterson says this gives them a significant advantage over competitors. “In the small cap arena few companies are actually analysed by external investment analysts and therefore for an investment company to follow stocks they have to do their own analysis. This limits quite dramatically the number of stocks that they can actually follow in detail and is probably one of the reasons that you often see quite significant volatility.
“However, we can value enormous numbers of stocks at the same level of detail and on a consistent basis. For each company we look at up to 200 different data items. Each stock is valued based on the most up-to-date data available and the valuation is updated in real time based on current price in the market.”
At the other end of the scale, portfolio management is handled by a single stock-picking manager with a universe of fewer than 100 small companies. Robert Perkins of Perkins, Wolf, McDonnell & Co has selected 85 companies from 300 to 400 potential candidates. This is higher then his historical average, which is around 70 to 75. However, a negative return of 15% last year persuaded him to increase the size of the portfolio. He describes what went wrong.
“One of the prime reasons we were down as much as we were is that our best performing group of companies, what we call ‘falling growth’ became our worst-performing group. I didn’t recognise how over-owned some of these stocks were. We would be buying XYZ at $8 a share down from $100 or $200 a share. We were paying two times cash and the company had $4 of cash and didn’t have any debt and we thought the earnings would turn up in six or nine months. What happened was that when these stocks were $100 to $200 a share they were mid caps, when they were $8 a share they were small caps and when they were $5 a share they became micro-cap. And at a micro-cap level there were no buyers for them and there were still people wanting to sell.
“So in some case these stocks sold below cash. Where I was dead wrong was instead of having a 0.5% position and being able to average down I had a 1% position and couldn’t average down.
“The lesson I learned is that, especially given the volatility of the market, you’ve got to spread your risk a little bit better, especially in that segment of the market. By being a little more diverse we will have the ability, if we are wrong on our timing, to average down and take advantage of the further weakness.”
Sound stock-picking is crucial in such a risky arena, says Siddles at F&C. “Investing in US small companies is very risky, and we do all we can to remove unnecessary risk. We look for four things. First, a strong franchise – the company has a competitive edge in its business, which is sustainable. Second, free cash flow which indicates that it’s profitable able and that capital is being managed properly. Third, significant insider ownership – that is, that the management has got a stake. Fourth, the shares must be cheap. They must be out of favour or neglected.”
There are also dangers in the success of US small cap funds as well their failures. If a fund attracts too many assets, putting the extra money to work can distort the portfolio. The problem is liquidity. Since small cap stocks often are less liquid than large caps, funds that have build up very large positions in small caps may run into difficulties if they try to unwind them.
Funds can take two levels of action: a ‘soft’ close, where the fund is closed to assets from new investors and a ‘hard’ close where the fund is closed to the further assets from existing investors.
Perkins put a soft close on his fund two years ago when the fund reached $3bn. “I would think in terms of doing a hard close at a number of $5bn. Beyond that we have to really start compromising the basic philosophy of the fund of investing in small cap stocks,” he says.
Axa Rosenberg IM has also closed its Russell 2000 strategy to new clients, says Patterson. “We believe that it’s very important to ensure that you understand what the capacity is in each of your main strategies and that once you get close to that you close it to new entrants so that you don’t risk de-composing the alpha for your existing clients.”
Investing in US small caps is a strategic rather than tactical investment for pension funds. The asset class has some of the characteristics of private equity in the sense that it is much less liquid and that therefore the investor has to take a long-term position. And some investment managers see alternative investments as a rival asset class to US small caps.
Dimensional’s Nash says that that European pension funds should fully explore the listed market before venturing into the unlisted arena. “Currently institutional investors are weighted towards large cap growth stocks which dominate large cap oriented indices. They are missing out on the most attractive part of the listed market which are micro cap and deeply out of favour value stocks – the orphans of the market. This is not a timing recommendation but a reflection of the fact that these sub-groups of stocks will compensate investors over the long run.”
Yet the real battle is to persuade investors to switch from large cap to small cap. For most of the last 20 years the equity market has been dominated by large companies, and for most of these years large caps have outperformed small caps. Is this situation likely to change? Robert Siddles believes it is: “The long term outlook is favourable. We’re back in a small cap cycle.”
If this is so, European pension funds could be persuaded to increase their allocation to US small caps by more than a few percent.