Case to use ETFs for small-cap exposure

Photo of Arian Neiron, VanEck Australia By Arian Neiron, VanEck Australia

min read

Smaller stocks are often considered a ‘stockpicker’s market’, but index exposure via Exchange Traded Funds is growing.

Small companies offer opportunity - most of today’s large and successful companies started small. In their youth, companies often experience their greatest growth – and that’s often when returns can be greatest.

Small-caps, therefore, are important portfolio growth assets, although they can be riskier and tend to exhibit higher volatility than established large-caps.

Most people invest in small-caps as a subset of their total Australian equity exposure and typically have a long-term view, which can accommodate the ups and downs in prices.

Yet small-caps opportunities can be easily missed. A lack of research coverage means many small-caps are ignored by analysts. Small companies are often mispriced and, in some cases, are illiquid (low share turnover) because of a lack of popularity.

This can make direct investing in small-caps a riskier game compared to investing in well-established large-cap stocks, for which there is ample research and analysis.

Even active fund managers have trouble mastering the small-cap sector. Standard & Poor’s SPIVA Australia Full Year 2016 Scorecard reveals a bad year for small-cap fund managers, with the majority failing to beat their benchmark indices despite rising share markets.

Over one year to 31 December 2016, 82 per cent of small and mid-cap fund managers underperformed their index. The performance was better in the long run. Over three years, 38 per cent of active small-cap funds outperformed. Over five years, 52 per cent outperformed.

Therefore, while small-caps may be a great growth opportunity, some active fund managers have missed key opportunities in recent times, such as the strong rebound in mining stocks through 2016.

Finding reliable opportunities

For this reason, investors looking for more reliable investment opportunities are turning to ETFs, which give the ability to access markets in a low-cost, efficient way – via a single trade on ASX.

ETFs enable investors to have a broadly diversified exposure to small-caps, which reduces the cost and spreads the risks of investing in this sector.

While some of the small-cap ETFs in Australia are based on benchmark market cap indices, including the iShares S&P/ASX Small Ordinaries ETF and the SPDR® S&P/ASX Small Ordinaries Fund, the latest trends in smart beta index development have expanded opportunities for investors.

Here are four small-cap ETF options for investors, via ASX:

  1. VanEck Vectors Small Companies Masters ETF (MVS) Index: MVIS Small Companies Dividend Payers Index
  2. iShares S&P/ASX Small Ordinaries ETF (ISO) Index: S&P/ASX Small Ordinaries Index
  3. Vanguard MSCI Australian Small Companies Index ETF (VSO) Index: MSCI Australian Shares Small Cap Index
  4. SPDR S&P/ASX Small Ordinaries Fund (SSO) Index: S&P/ASX Small Ordinaries Index

Smart beta indices seek to target investment outcomes and thus are an improvement on traditional market-capitalisation indices (where stocks are weighted in the index according to their size).

A new VanEck white-paper reveals that an index strategy in liquid Australian small companies that pay regular dividends is likely to produce superior returns and lower downside over the long term compared to small companies that do not pay regular dividends.

Our MVIS Australia Small-Cap Dividend Payers Index (MVS Index) tracks the performance of the most liquid, dividend-paying Australian small companies on ASX.

The MVS Index has displayed stronger returns and lower downside risk over the long term compared to the benchmark S&P/ASX Small Ordinaries Index, according to our white-paper, Mastering Small Companies with Smart Beta.

The MVS Index includes only the most liquid, dividend-paying small companies listed on ASX, almost 100 stocks. Examples of the regular dividend payers included in the MVS Index are Nufarm, IRESS, Webjet and Technology One.

Dividend filter

Dividend screening is a key part of MVS Index. Many of the small-cap companies excluded from the MVS Index have a negative return on equity (ROE). In other words, they are making a loss rather than making a profit and cannot pay dividends.

The dividend filter also has the effect of excluding small-caps with the least stable earnings. By excluding companies based on ROE and earnings stability, the dividend filter is excluding “lower quality” small-cap companies.

Another distinguishing feature is MVS Index’s increased exposure to low-volatility stocks compared to the benchmark, as the dividend filter has the effect of excluding many higher-volatility stocks.

Numerous studies have concluded that a portfolio of low-volatility stocks produces higher risk-adjusted returns than a portfolio of high-volatility stocks.

About the author

Arian Neiron is the managing director of VanEck Australia. VanEck is a leading global provider of exchange-traded funds (ETFs). This article is not intended to provide personal financial advice to any person.

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