To recap, a massive fund, typically a pension fund or a SWF, faces constraints and challenges in the marketplace in terms of market capacity, availability and liquidity. In order to capitalise on its available liquidity pools to seek new investments with wealth-added potential, it might be appropriate to segment its portfolio according to its various risk-return profiles corresponding to the spectrum of market cap sizes of its current assets and asset classes as well as whether they are publicly listed or not. Notwithstanding the fixed income instruments and derivatives segments, typically, that would be a mix of large-cap to small-cap and micro-cap companies including the private ones, with a higher concentration of established blue-chip and index companies.
As a result, the top-heavy profile of the portfolio suggests that the big-cap companies will be the main driver of most of the portfolio’s gain or loss, i.e., an increase in market capitalisation will drive the portfolio performance in terms of the potential upside, and conversely, the market beta will drive the downside loss, when market cycles are negative. With the global markets being more correlated today, especially more during crisis periods, how then can the alpha be generated from such a lop-sided portfolio? It might be insightful to re-look at the drivers of market capitalisation itself and examine some empirical studies from this perspective.
Market Size Effect
First, a study is made of how the market capitalisation and price level of selected indices have changed over the last decade (from June 2000 to 2010), with the exception of the TSX-Ventures index, where data is available only from 2001. The other indices selected include the S&P500, HSI, STI, ASX and TSX.
The results show two indices, specifically the ASX and the TSX-V, performing admirably on both dimensions of increase in total market cap and price levels. Both indices display the characteristics of the resource-centric and emerging market bias of the companies listed on both exchanges, e.g., the BHPs and the Rio Tintos, which have undergone a tremendous change in their market capitalisations and prices as beneficiaries of the resource-driven demands of China, India and the emerging markets this past decade.
In a sense, most of these companies had smaller market capitalisation at the beginning of the decade and as they grew into big-cap, blue-chip companies, corresponding with the demands of the new emerging resource-hungry countries like China and India, they exhibited the higher average returns, typical of those stocks which underwent migration (Fama and French, 2006) in size, i.e., small stocks that became big.
While they are listed in say, Australia or Canada, the major part of their businesses and revenues are derived from Chindia and the emerging markets. As a result of this corporate diaspora effect, Australia and Canada in this evolving landscape can be considered as emerging markets plus (EM+) due to the higher concentration of resource companies listed on their exchanges. This investment avenue potentially serves as an indirect route to garnering exposure to the upside potential of the emerging markets, without the inherent risk of a direct investment in these markets.
El Dorado, Potash and Niko Resources are examples of companies which have undergone migration (transition) from small to big-cap companies. Hence, a small investment pool, e.g., $500 million - which would be insignificant when compared to the overall portfolio value of say $150 billion - targeted at private or micro-cap companies in specific sectors via a VC approach to investing, might potentially yield the future alpha, even if most of these small companies were to fail. In the case of El Dorado, the gain in price in the last 10 years (June 2000 to June 2010) has been of the order of approximately 38 times (assuming the number of shares remains constant), notwithstanding the actual increase in market cap, outperforming even the performance of gold.
Sector Diaspora Opportunity
Also, a new study from S&P Indices finds that regional variety offers less of a benefit from diversification than investing based on economic sectors, e.g. energy. S&P researchers took the organisation’s Broad Market Index (BMI), a unique gauge on global stock markets that covers about 10,000 companies in 45 countries, and sliced it up by region, country and sector. They compared the historical performance of the sub-groups with the BMI itself and discovered some interesting patterns.
Firstly, the correlation of market performance in developed regions with the BMI has converged substantially recently. The five-year correlation increased to 0.95, compared with 0.91 over 10 years and 0.87 over 20 years. S&P also found that the five-year correlation between the BMI for emerging markets and the BMI for developed markets has increased significantly. The five-year correlation of the S&P Emerging BMI to the S&P Developed BMI is 0.91, compared with a 0.82 15-year correlation.
The convergence is a result of increasing global economic and financial market interdependence, according to the study’s authors. “In the last couple of decades, investing has become global,” says Alka Banerjee, vice-president at S&P Indices. “The same story is playing out in emerging markets. It’s the same flow of funds and the same sentiment.”
In contrast to the regional alignment of markets, some individual sector indexes of the S&P Developed BMI show wide varying correlations to the parent index. Specifically, energy, health care, utilities and consumer staples have 20-year correlations of less than 0.75. Several sectors, however, move closely with the broader BMI. The industrials, consumer discretionary and financials sectors all show 20-year correlations above 0.90. A lot of the economy today is powered by multinational corporations that conduct their business worldwide. “Sectors are really what’s driving the markets today rather than the domicile of the companies,” says Michael Orzano, an associate director at S&P and the other co-author of the study. Thus, the capacity to over- and under-weight individual sectors potentially offers the ability to outperform broad regional indices in both up and down markets and market sectors will continue to deliver highly divergent performances on both an absolute and risk-adjusted basis. The S&P report concludes: “sector investing provides significant opportunities for alpha generation in both up and down markets.”
The implications for large portfolios are that investing in large-cap companies may not necessarily yield the required wealth-added beyond the hurdle rate, as the influence of the beta driver is too strong. While a dynamic beta strategy might yield some “dry powder”, taking concentrated bets with an initial small outlay of investment funding (small allocation of funds or sub-portfolios) on specific sectors, including small and micro-cap companies may provide the potential alpha as they benefit from the uplift of these companies’ size and growth during their “size” migration, leading to substantial growth in these sub-portfolio values to meaningfully shift the risk-return profile of the portfolio returns. The initial results of the studies above illustrate the validity of such an approach - basically, in addition to alternative investments, a venture capital approach could also be a key component of the investment decision-making model of large funds, like those of SWFs and pension funds.
Dr Yuan Cheng Qiu is a senior portfolio risk manager at a global investment firm and Prof Annie Koh is the Dean, Office of Executive & Professional Education and Academic Director, International Trading Institute, at the Singapore Management University.