Don't always expect rivers of gold with small caps

Small-cap investing has been in the news recently with a report in the Fairfax media drawing attention to the decision by Australia’s most prominent small-cap investor, Paradice Investment Management, to return more than $800 million of its client’s money.

The firm believes its Australian Small Cap Fund has become too big to beat the market.

This is despite the fund returning 15.9% annually to investors since its 2000 inception, compared to its benchmark, the ‘S&P/ASX Small Ordinaries Accumulation Index’, which has produced just 4.22% over the same period. The Small Ordinaries covers the small-cap listings of the S&P/ASX 300 Index, excluding those in the S&P/ASX 100 Index. 

At the same time, it might just be that the small cap sector is proving a little tricky at present, with the Small Ords set to return 10.47% over the past year compared to 15.75% for the S&P/ASX 200.

So, what is a small-cap stock? According to an ASX report, the maximum market cap of a stock in the Small Ords is $3.5 billion, and $6.8 million represents the minimum. The index has a median market cap of $348 million.

As for the companies represented in the index, it’s pretty evenly spread between firms operating in the materials, industrials, consumer discretionary, financial services, energy and IT sectors.

Investing in small caps has the potential to deliver higher returns, but this brings with it the potential for more volatility. “Those suited to small caps typically include more experienced investors, those seeking long-term growth and self-managed super funds,” said Ron Hodge, Managing Director, InvestSmart.

“Other investors may choose to invest in small caps as an asset management strategy to help them counterbalance a portfolio too heavily skewed to larger cap companies and to gain exposure to lesser-known companies that manage to stay under the radar of the professional analysts.”

Small cap stocks tend to trade less frequently than bigger brands, which can create price pressures for those keen to buy into or out of them quickly.

One way of managing the risks associated with small cap companies is to invest in specialist managed funds such as Investors Mutual Small Capital, which according to Morningstar, produced a return of 18.44% over the past year.

This fund invests in a diversified portfolio of quality Australian shares outside the Top 100 shares listed on the ASX and New Zealand shares listed on the NZX. The team at Investors Mutual looks for shares it deems as undervalued. The fund may also hold up to 25% of its assets in securities included in the S&P/ASX Midcap 50 Index.