Small-cap ETFs offer access to superior growth and risk-adjusted returns

Jul 2nd, 2012 | By | Category: Equities

Investing in smaller companies is typically perceived as riskier than investing in larger companies. According to Mark Heslop, a specialist small-cap fund manager at London-based Threadneedle Investments, this perception can be attributed to a number of factors.

Small cap ETFs offer access to superior growth and risk-adjusted returns

“Small-caps have delivered superior risk-adjusted returns over many periods”, according to Mark Heslop, a specialist small-cap fund manager at London-based Threadneedle Investments.

First, smaller companies are less liquid than large caps so when there is a market correction, shares are subject to larger swings. Second, small-caps are less diversified than large-caps and therefore are more exposed to specific market risks. And third, smaller companies are less well researched by sell-side analysts so there is a greater risk of earnings misses.

While there are a number of valid arguments as to why smaller company investing should be higher risk, Heslop points out that the empirical evidence suggests the difference is marginal. In fact, Threadneedle data shows that the risk-adjusted return is at least as high in small-caps as in large caps.  Indeed, in some cases the return is significantly higher in small-caps, both on an absolute and a risk-adjusted basis.

FEATURED PRODUCT

iShares S&P SmallCap 600 ETF (ISP6)

– Tracks the S&P SmallCap 600 Index, providing
exposure to 600 US small-cap stocks representing
approx 3% of the US domestic equity market

– Average market cap of $850m vs $25.5bn for S&P 500;
well diversified with top 10 holdings making up less
than 6% of fund; index has delivered annualised returns
of 6.3% over 10 years vs 2.7% for S&P 500

– Physically replicated with full transparency to
portfolio holdings

– UCITS compliant, London listed, UK Reporting
Status, eligible for ISAs and SIPPs, TER 0.40%,
registered for distribution across much of EU

While the risks appear to be similar to large-cap investing, the returns that smaller companies have generated (in aggregate) have been far from it. “Small-caps have delivered superior risk-adjusted returns over many periods,” says Heslop, highlighting data showing that the MSCI World Small Cap index has delivered an annualised return of 7.2% over the last ten years, compared to just 3.0% for the large cap MSCI World Index.

A key reason for the superior returns has been the higher growth rates that smaller companies are able to deliver. Of course, small companies include failing large companies of yesteryear as well as the large-caps of the future.  However, in aggregate, small-caps have been able to deliver faster growth rates than large-caps in 19 of the last 22 years.

“Smaller companies consistently deliver superior growth”, asserts Heslop, outlining three main reasons for this including. First, smaller companies, by definition, have a greater opportunity to take market share from their large-cap peers. Second, greater market / product focus results in a more efficient allocation of capital to growth opportunities. And third, smaller companies are more nimble and able to adapt to changing market dynamics faster than larger organisations, which are at risk of becoming bureaucracies.

Heslop argues that, in aggregate, small companies have delivered better risk-adjusted returns than larger companies and that they have consistently delivered superior growth over the last two decades. Heslop also draws attention to current small-cap valuations, which, with PE ratios below their long-term average, he says, are attractive in absolute terms and relative to large-caps.

For investors looking to gain exposure to small-cap stocks via ETFs, there is a large choice of funds tracking a range of different small-cap indices. The funds selected below are all available to UK investors (mainly London listed) and most are also registered for sale and distribution across much of Europe.

United States:

iShares S&P SmallCap 600 ETF (ISP6) TER 0.40%.
DB X-trackers Russell 2000 ETF (XRU2) TER 0.45%
Russell 2000 Source ETF (RTYS) TER 0.45%
ETFX Russell 2000 US Small Cap ETF £ (RTWP) TER 0.45%
Credit Suisse ETF (IE) on MSCI USA Small Cap (CUS1) TER 0.43%

Eurozone:

iShares EURO STOXX Small ETF (DJSC) TER 0.40%
Amundi ETF EURO STOXX Small Cap (ESM) TER 0.30%
UBS-ETF MSCI EMU Small Cap A (UEFD) TER 0.50%
Credit Suisse ETF (IE) on MSCI EMU Small Cap (CES1) TER 0.58%
MSCI EMU Small Cap Source ETF (EMSC) TER 0.70%

Europe/UK:

STOXX Europe Small 200 Source ETF (SDJSML) TER 0.35%
DB X-trackers MSCI Europe Small Cap TRN Index ETF (XMK7) 
TER 0.40%
SPDR MSCI Europe Small Cap ETF (SMC) 
TER 0.40% 
Credit Suisse ETF (IE) on MSCI UK Small Cap (CUKS)
TER 0.58%

Asia and Emerging Markets:

iShares MSCI Japan Small Cap ETF (ISJP) TER 0.59%
Credit Suisse ETF (IE) on MSCI Japan Small Cap ETF (CJPS) TER 0.58%
iShares MSCI AC Far East ex-Japan Small Cap ETF (ISFE) TER 0.74%
iShares MSCI Emerging Markets Small Cap ETF (IEMS) TER 0.74%
SPDR MSCI Emerging Markets Small Cap ETF (EMSM) TER 0.65%

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