Sometimes smaller is better: which way to bet in this market environment?

BY Thong Nguyen | 19 September 2017
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Modern portfolio theory suggests there are two kinds of risks in stock returns:

  • Systematic or market risk, which investors attempt to ‘diversify’ away by adding a variety of assets to their portfolios; and
  • Unsystematic or stock specific risk, which represents a stocks return that is not correlated with general market movements

In recent times, global tensions have been rising particularly due to the resumption of North Korean missile and bomb tests, which have unnerved markets. In light of this, one may reasonably expect that a diversified basket of Australian large companies would outperform and be less risky than a diversified basket of smaller companies. One may well have this view as typically smaller companies tend to exhibit higher levels of volatility and are generally perceived as riskier investments.

However, in the current market environment, has this in fact been the case?

If we take a simple ratio of the S&P/ASX 100 Index (representing large caps) and the S&P/ASX Small Ordinaries Index (representing small caps) we can determine which segment of the market has out-performed recently.

 

Source: Bloomberg. Past performance is not an indicator of future performance

As you can see from the above chart, small caps have in fact been outperforming large caps since the middle of March 2017. You will also notice there has been an acceleration in this outperformance more recently, which coincides with the threat of nuclear war. So what may be causing this to occur?

There are two potential factors going on here.

The first is typical institutional investor behaviour. In the current environment, institutions and fund managers may be a bit nervous about the macro environment, and in particular events like war. History suggests such events may well have short-term effects on the markets but less so in the longer-term. Naturally the most efficient way to de-risk large institutional portfolios quickly with the least amount of market impact is to sell the most liquid assets, being larger companies. This selling behaviour will, in turn, put pressure on the pricing and performance of large cap stocks relative to small cap stocks, which generally receive less attention in these situations.

The second factor is the strong AUD/USD rate, which has been above 80 US cents recently. A strong Aussie dollar is good for importers, but not so good for exporters as it makes their products less competitive in the global markets. Typically, larger companies are more exposed to fluctuations in exchange rates, while smaller companies rely more heavily on local sales.

If tensions were to increase, heightening the threat of nuclear war and the AUD/USD were to remain high, I would expect small caps to likely continue to outperform large caps in this environment, at least in the short term. Investors looking to access a diversified portfolio of small companies as a component of their overall holdings, can do so via the Betashares Australian Small Companies Select Fund (managed fund), which trades on the ASX via the ticker “SMLL”.

 

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