With stock markets dominated by global titans and strict adherence to benchmarks creating a stranglehold on large cap active management, the small cap arena is one where talented fund managers can really show their mettle. Academic discussion in the late 1980s postulated a ‘small cap effect’ and recommended some small cap investment to take advantage of the greater potential for growth that is possible when – by their very nature – small caps are starting from a lower base. But in the 1990s the asset class as a whole underperformed in stock market terms, with much of the brouhaha surrounding restructurings and takeovers driving valuations in the large cap arena. Although some small cap stocks undoubtedly shook off their humble beginnings, many remained small and undervalued. And, given their growth bias, many small cap funds performed poorly when the tech bubble burst.
The harsh reality is that among a stock universe of 4,000–5,000 across Europe, probably only about 200 companies will be doing well. It is the job of the small cap fund manager to find those companies. Needles and haystacks come to mind, especially now that the IPO market is practically lifeless, compared with the heady days of 1999, and fewer investing opportunities are being offered on a plate.
But if alpha arises from exploiting market ineffiencies created by scarce information and overlooked opportunities, the small cap market is a happy hunting ground. Arguably, it is in this sector of the market that the risk budget may be better spent. Compared with the 44 analysts researching every Nestlé or Siemens, fewer than seven will follow a stock in the lowest decile of the market, and some stocks may be ignored completely. The industrious small cap fund manager can potentially pick up on growth stories, earnings revisions and catalysts for change that will cause a company to be rerated, and his performance will pull ahead of the pack. Hands-on research is the key, with fund managers are out on the road some 25–30% of their time visiting company offices and factories. AIG’s small cap team of Chantal Brennan and Neil Wilkinson visited 400 companies across Europe in 2001. Brennan comments: “A site visit is invaluable. Only by talking directly to management, seeing stock levels in the warehouse and the hum of the factory, can you gain some comfort on earnings predictions.”
In the months following an IPO, coverage of the stock can tail off and speculative holders get shaken out, leaving the share undervalued. An example of this was De Longhi, which had fallen to E2.50 from an IPO price of E3.30 when Gartmore small cap manager Tamsin Quayle visited in September 2001. Quayle found that the company had sound fundamentals, with increasing market share since the bankruptcy of Moulinex. The stock was rediscovered by brokers and fund managers in late 2001–early 2002 and has risen back to the IPO price. This demonstrates an important point in the small cap market, that it is not sufficient to identify these companies, the manager needs to understand the mechanism by which a stock will be uprated. The E120m Gartmore Cap Strats fund has turned in a positive 60% performance since inception in 1999, whereas the HSBC index only improved 5% over the period.
Practically speaking, small cap fund management has to be active. It would not be feasible and a low value proposition to create a passive small cap fund containing around 1,500 companies. Many small cap companies are moribund ‘asset traps’, in declining industries, or sleepy family-run businesses with a small free float that offer little prospect of appreciation. However, as Quayle points out, “one cannot be too prescriptive in small cap investing, because the management can change quickly and turn around a dull company”. Each individual position in the typically concentrated small cap fund is a large overweight bet taken with conviction. Relative to the index, the risk is higher and more difficult to control, because of poorer liquidity.
If stock market investment is seen as the means of achieving exposure to economic growth, then small caps have a place in every European portfolio. The real economy is made up of small and large companies, and a neutral position would include small cap exposure. Certain sectors of the economy are only accessible via small cap exposure, for example security services and casinos, and to include these companies will make the equity portfolio more reflective of the real economy. As such consultants should support the proposition.
Despite the more ingrained equity culture of the UK, the concept of a pan-European small cap mandate is more established among European pension funds. Although some European funds are still in the process of increasing domestic equity allocations, there are increasing numbers of international small cap manager searches, particularly from the Nordic region. A recent example was the award of a $17m active European small cap equity mandate to Merrill Lynch Investment Managers by the Swedish telecoms company pension fund Telia-Pensionsstiftelse. JP Morgan Fleming also has large individual amounts from Nordic funds in its small cap pooled vehicle – for example, a E20m allocation from a Finnish pension fund. The heavy domestic focus of the UK means that although UK small cap investment is time-honoured, applying the same concept to Europe is less accepted, although there is some interest in so-called market completion funds. This ironically can mean that there are more opportunities for alpha generation in the less well-researched continental European companies.
Most allocations are on a pooled rather than a segregated basis, for reasons of size and practicality. Fund managers normally will not consider a segregated mandate for anything less than E25m. If the small cap portion is typically no more than 5% of the total amount allocated to a region, then for the small cap portion to be separately managed, the total European equities allocation would have to be at least E500m. In any case there is little rationale, other than investor protection, for a segregated account. No fund manager would run a mandate with a radically different performance objective and investment criteria from the pooled funds being operated alongside. This would create an enormous amount more work in company research and investment monitoring for very little extra return.
One of the largest managers of segregated institutional small cap money is Deutsche Asset Management, with about half of its E2.5bn in small caps within segregated funds. Ruth Keattch, at DAM in London, affirms, “once the universe and benchmark is defined, the funds are run in accordance with the house investment process and it creates complications if the client cannot buy into that”.
Because European small cap investment is such a specialism, well-regarded managers will receive sub-advisory mandates from other fund managers for the small cap portion. Regional sub-allocations of global small cap allocations made by US and global pension funds make up the lion’s share of money run by the London-based small cap departments of US asset managers such as Morgan Stanley Asset Management.

Most small cap fund managers are barely conscious of their position relative to the index, a situation partly caused by disillusionment with the quality of indices available. Tracking error may be computed but is not used as a risk management marker as it is in large cap funds. According to Debbie Boys, European sector analyst for Standard & Poor’s Fund Ratings, “the main tool for risk control is an intimate understanding of the company and, to a far greater extent than in large cap fund management, funds are truly taking a stake in the business”. Quayle affirms: “Risk management tools in use for large caps are not suitable for this market, mainly because of a lack of reliable information.” More proactive investors seek to have a frequent dialogue with company management, to understand their motivation and to influence corporate strategy. The more passive invest in smaller unit sizes for greater diversification.
Fund managers, depending on their bias, will screen by earnings growth and likely revisions to forecasts, or value parameters, to cut the 5,000-stock universe down to a more manageable 400–600 for closer inspection. Funds typically hold 50–100 stocks within the portfolio. Portfolios are spread across industry sectors, striking a balance between aggressive growth bias or more stable value investments. Gartmore reduces portfolio beta by holding its largest positions in low beta companies, whose valuations are underpinned by strong cash flow, taking smaller positions in higher risk tactical bets, whose valuations may be more stretched. Morgan Stanley fund manager Christophe Orly notes that style is a bigger factor these days in mandate decisions and that not all small caps are growth stocks in the purest sense. Some are making the transition from small to mature, or are able to extract organic growth irrespective of the industry trend. On the value small cap programmes offered by Morgan Stanley, Orly avows “the selling point of the value proposition is the avoidance of extremes of valuation at both ends of the spectrum and so lower portfolio volatility”.
According to Boys, “in the TMT correction, managers found they had considerable indirect exposure to technology. This made the fund more vulnerable to economic downturn than was immediately apparent through sector breakdown”. Aggressive growth fund managers like Invesco suffered badly , but S&P gives credit to managers for pursuing their investment policy despite market conditions. The poorer liquidity offered by small caps means there is little to be gained from attempts at momentum investment. Funds will generally hold some cash or larger cap exposure to fund redemptions, since small cap liquidity is not guaranteed, especially in volatile markets. Positions can take from a few days to a few weeks to be built up.
AIG’s philosophy provides for four phases of earnings development, exceptional growth, high stable growth, high cyclical growth and mature. Its portfolios are tilted towards the first two categories, but include some of the latter to make the portfolio more defensive. AIG notes a greater degree of migration between growth and value universe than in the past, with some stocks metaphorically changing their spots over the market cycle. Controls in place at AIG ensure that the proportions in each sector do not deviate more than 15% away from the index, and this means that the managers will have some stocks in the portfolio they are less keen on, but which represent the best opportunity within that sector. AIG also holds cash balances of some 5%. AIG only invests in these mature industries or stocks where it sees a probable catalyst to unlock that value. Salomon Smith Barney’s factor analysis of the AIG fund against the sub-$1bn market cap benchmark that AIG uses finds that the fund is heavily skewed towards growth, with 51% in pure growth stocks, against 24% in the benchmark. AIG aim to seek out companies with the “next big product”, according to Brennan, that will become large cap companies of the future. Says Brennan “successful small companies grow, while value stocks may be symptomatic of an industry in decline, that will fail to appreciate”.
There are three main benchmarks for European small cap investment, provided by HSBC, MSCI and SSB. Most of the London-based managers use the HSBC benchmark, which in common with the MSCI encompasses about the lowest 10% of the market. The SSB Extended Market Index constitutes the lowest 20% of the SSB Broad Market Index, an all-share type index. A complaint of all the managers questioned was that the indices available are not suitable for measuring the performance of managers operating a growth style, as they either contain all companies below a certain market capitalisation or market proportion, or cover all sectors of the market. Comments Jim Campbell, manager of the Fleming Frontier European Discovery Fund: “There is a lot of dead wood in the index, principally in sectors such as property, industrials and chemicals, which drags down index performance.” Campbell’s fund has grown by 173% over the same period that the HSBC index has increased 89%, by ignoring these stocks and focusing on those with growth potential.
HSBC operates three small cap indices for Europe, covering continental Europe both with and without the UK and Euroland. The ex-UK version covers 17 markets and includes 1,000 companies with a total market cap of E416bn. By adding in the HSBC UK Smaller Companies index, HSBC creates the HSBC Smaller Europe inc UK, which contains 1,401 companies with a total market cap of E567bn. The main HSBC indices are the longest running of the available benchmarks, launched in 1993 based on data from 1989 onwards. From the start HSBC included Greece, Portugal and Turkey, all of which were felt to be peripheral markets in 1993. Qualification for the index depends on liquidity as well as size; to qualify at least 5% of a company’s shares must be traded annually. A free float of 10% or more is mandatory but there is no adjustment for free float in the index calculation. All eligible shares are ranked by size and the 1,000 shares below the top 400 make up the continental European index. A similar process applies in the construction of the UK Trixie index. HSBC indices are rebalanced quarterly to ensure the index remains representative of the investable universe. The market cap range of the index constituents arises out of the process rather than being a condition determining inclusion. As the index stands it encompasses companies within market caps of £60m–900m. The excluded large cap names make up 91% of the eligible universe and small cap index takes in the stocks below that.
The other pure small cap index for Europe is the European component of the MSCI Small Cap Equity Index. From 28 September 2001, MSCI broadened the range of companies within its small cap indices to those with market caps of $200m–1,500m, with a minimum free float of $100m or 15% of issued share capital. This range appears to accommodate most small cap managers’ views as to the scale of the market. It also changed the methodology to adjust for free float and started rebalancing every six months, rather than every 18 months. MSCI samples securities from each industry group that might reasonably be bought by the global investor. MSCI prioritises stocks by traded value ratios, a variation on the turnover ratio used by HSBC. It targets 40% of the eligible universe, striking a balance between breadth of coverage and investability, to permit cost-effective replication.
The SSB indices are skewed more towards the mid cap element of the market, with the Extended Market Index representing the bottom 20% of the Broad Market Index, down to a minimum market cap of $100m. SSB adjusts for free float and includes all eligible shares, as opposed to sampling with reference to sector weightings. The methodology is repeated for each country and regional indices are constructed by simply adding one market to another. The SSB European Extended Market Index contains 1,669 companies with a total market cap of $1.7trn and free float of $1.086trn. The index is reconstituted annually, although exceptional amendments to account for new issues above $1bn market cap or drops below $25m are made at month-end.
Some might question whether investing in small caps is simply taking a highly geared bet on the economy, given the growth bias of most funds. Fund managers counter this by suggesting that a small cap with a strong product and market niche can grow despite weakness in the economy, and that economic risk can be countered by close examination of the company’s prospects in all scenarios. Many funds hold Soitec, a semiconductor company that is growing at 100% a year despite the global decline in semiconductor sales.
In the light of the improving economy, prospects look good for the smaller caps, particularly IT stocks. However, AIG notes poor visibility of earnings in the current climate and a bottoming out of interest rates could hurt over-indebted companies. The outlook is improved by the introduction of the euro, because invoicing is now done in euros and there is greater price transparency between markets, which opens the door to region-wide sales to providers of niche products.