Which small and microcap funds are doing best and what to look out for

For many investors, small and micro cap funds are an easy way to gain exposure to emerging companies. Top expert Mark Tobin of Independent Investment Research outlines what you need to know — and which funds are doing best. 

How do Australian microcap and small cap funds stack up against benchmark indicies like the Small Ords?

Australian small and microcap funds have a generally positive track record and the last quarter was no different.

The general measure of success is against the Small Ords – and to a lesser degree the Emerging Companies Index – which most [small and microcap funds] have shown up in the past quarter.

Going back three years the story is much the same. Despite volatility, active microcap managers have, by and large, delivered alpha to their investors.

(Alpha is an investment’s performance against a market index or benchmark. The “alpha” is the excess return relative to the benchmark index).

>> Scroll down for tables comparing returns for small and micro cap funds

Three stand-out performers in the past three years were Cyan, Perpetual and DMX.

When you look at the results in Australia compared to other markets, ours do the best against benchmarks in terms of delivering to investors.

The strength of the industry and the emergence of new funds is a testament to the alpha being delivered.

How much should investors expect to pay for small cap expertise?

Of the funds in my investment universe, one interesting thing to notice is the clustering of fees.

Between the 18 managed funds and nine Listed Investment Companies (LICs) every single vehicle charges some kind of performance fee — averaging at just under 19 per cent.

Of those, 22 vehicles charge at least 20 per cent as a performance fee and most charge a further 1 to 1.5 per cent as a management fee.

There is no one breaking out of the mould.

Even if you look at the new funds, they are all around the same fee level. No one has tried to disrupt the incumbent funds, with a low-cost product at least.

It could be down to the economics of the strategy, but it flies in the face of the global downward trend in management fees and performance fees since the Global Financial Crisis of 2007-08.

Globally, active managers are getting less than they were 10 years ago – but microcaps have largely gone through untouched.

Why can small and micro cap managers can charge relatively high fees?

At the end of the day, investors are the ones forking out these fees despite what other parts of the industry are charging. I think it is because the universe is largely misunderstood.

There is a perception that there is a decline in company and management quality and a decline in business models as you go down the market cap scale. But in my eyes, it couldn’t be further from the truth.

While they might be global leaders by conventional wisdom, if you look at the shareholder value BHP and Rio have destroyed in the past, these large cap “Blue Chips” can destroy shareholder value as much as any small cap.

Just because of their size, I think it is wrong to write off microcaps. The management behind them and the models are just as capable of graduating to small caps and large caps over time.

It is interesting to note the microcap/small cap LICs that have cropped up as the interest in the space continues to grow.

Six have come into the ASX in the past three years, taking the total count to eight. It is largely providing a means for easier exposure to the microcap/small cap universe.

What sectors are driving returns in small caps?

Junior miners are the driving force behind the success of the small ords and emerging company indexes – especially as the commodity cycle looks to have well and truly turned.

Looking at the funds in the universe, it would be hard to outperform the benchmarks without having a decent exposure to resources.

Tech investment would be a second growth driver – there are always start-ups flying under the radar in this realm.

How should retail investors evaluate which microcap fund to invest with?

Comparing funds needs to be deeper than just a quarter-to-quarter basis.

Going back at least three years is ideal. This gives more context on how each performs over a decent period and through various stages of the market.

For those that have not been around as long, you’ll often find they have management that have been involved in the sector for longer.

Just look at a fund like Spheria or Perennial. While the vehicle itself might be fresh to the market, those involved have a much longer track record.

It is a very different skill set to that of a large cap fund mangher who would have to filter through roughly 200 companies.

For a small cap manager that universe is between 1800 and 1900 at any one time — and needs the focus of specialist manager.

>> Here are tables comparing returns for three categories of small and micro cap funds:

Swipe or scroll for full tables.

Mark Tobin is a Senior Equities Analyst at Independent Investment Research (IIR). 

He is a driven finance professional with over 10 years international experience. Before IIR, he gained valuable industry experience in back/middle office roles across Europe before joining Wilson Asset Management as an Equity Analyst in 2012.

His specialties include Fund Accounting, Hedge Funds, Investment Accounting, Listed Investment Companies, Closed End Funds, Small Caps, MicroCaps, NanoCaps and Portfolio Management.

This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.