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Small caps maintain outperformance

Active small-cap funds continued to experience a strong year compared to the index despite dropping significantly from double-digit growth in previous years, research house Zenith Investment Partners’ sector review showed.

Zenith’s “2016 Australian Shares Small Companies Sector Review” revealed over the past 12 months, the active small-cap funds on Zenith’s approved product list outperformed the S&P/ASX Small Ordinaries Accumulation Index by an average of 5.7 per cent net of fees.

While an excess return of nearly 6 per cent was not to be sneezed at, it was in stark contrast to the performance heights of 2012 and 2013 when the firm’s approved small-cap managers outperformed the benchmark by an average of 16 per cent a year, Zenith Australian small-cap sector lead analyst Quan Nguyen said.

“The key to outperformance during the 2012 to 2013 period was overweighting industrials and underweighting resources,” Nguyen noted.

“However, with the resources sector having bottomed post this period, the trade for this excess return driver has largely played out.

“With many managers steering clear of resources companies, capital has instead been deployed towards high-quality industrial companies, which have had greater earnings certainty and cash flows.”

As a result, in many cases valuations on industrials companies had outpaced underlying earnings growth, he added.

Strong performance would naturally drive an increase in market capitalisation and liquidity, and those success stories would be promoted out of the index, he said.

While that was good news in terms of index construction, it represented a case of a small-cap company being a victim of its own success, he noted.

“The majority of small-cap managers are restricted in some way to continue to hold, let alone purchase, stocks that have been promoted out of the index,” he said.

“In other words, the opportunity set of high-quality, defensive stocks, and hence excess return potential, has been reduced.”

According to the review, the forward prospects for active management within Australian small caps were strong.

“The S&P/ASX Small Ordinaries Index as it stands now is a healthier index versus June 2010 for example, when resource stocks represented roughly 45 per cent of the index,” Nguyen said.

“Currently, resource stocks represent around 10 per cent.

“The addition of stocks from a wide range of sectors and the removal of many resource stocks has provided much greater diversification.

“In addition, the level of performance dispersion within the index has increased significantly over the past three years.”

Overall, the report concluded the current environment provided more scope for active managers to outperform by leveraging their strengths in stock selection.

From an initial universe of 64 products, Zenith rated three funds highly recommended, 28 recommended, seven approved and one redeemed, while 25 were not rated.

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