There are lots of reasons why investors should consider small-cap stocks, particularly to do with diversification opportunities. Being smaller, small-cap stocks often generate higher rates of growth and potential investment returns. Small-caps can offer an important growth opportunity within an SMSF portfolio, bearing in mind they can be riskier and exhibit higher volatility than large-cap stocks. They can also be far more illiquid with lower daily share volumes with the risk that buy and sell pricing will be far more volatile. 

Another reason for greater returns in this sector is the efficiency gap in the pricing of small companies resulting from limited analyst and investor coverage. In contrast with large companies that are closely analysed by a broad range of fund managers and broking analysts where research is widely available, small companies are not widely, if at all, covered thereby increasing the likelihood a stock will be under or overvalued.

This lack of research can be a double-edged sword for individual investors. It means that while small companies are often mispriced, investors and fund managers are required to rigorously do their own research. To give themselves a competitive advantage when it comes to assessing the fundamental value of small companies, many small cap funds managers do hundreds of company visits per year to fully understand their investment.

Buying shares in individual companies

Many SMSFs who invest in small-caps do so as a subset of their total Australian equity exposure to allow for adequate stock diversification. However opportunities can easily be missed due to a lack of research coverage from the larger research houses and brokers. This means SMSFs must use alternative sources of research, which in many cases may be specialist newsletters and market commentators, many of whom run model portfolios of suggested stocks.

Many organisations run investor sessions or webinars to share the latest ideas with their subscribers. The ASX also runs a series of investor days, seminars, company updates and on-line courses many of these applicable to small cap investing.

Exchange Traded Funds

Exchange Traded Funds (ETF) have seen huge growth within the SMSF segment. In general, passive ETFs, which follow a known index, give investors the ability to access markets in a low-cost, efficient way via a single trade on the ASX. Small-cap 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, there is a school of thought that because of the wide dispersion of performance in the wider small-cap index, better results can be obtained via active ETFs.

Active ETFs seek to target investment outcomes by actively determining the composition of the investment portfolio. Whereas traditional ETFs will provide approximately the return of the index (less a management fee), the return from an active ETF will depend on the stocks selected and of course on the skills and expertise of the manager.

The key features of all ETFs are that they are quoted and traded on the ASX and employ an open ended unit trust structure (thus expand and contract with underlying demand) and publish an end of day net tangible asset value (NTA). ETFs use market makers to buy and sell the units, thus providing liquidity, and disclose their portfolio composition on a regular basis. As a result ETFs trade at or very close to their net tangible assets (NTA).

You can find a list of ETFs shown by category at various sites such as the ASX and Morningstar with a description of the ETF and the management fee.

Managed funds

Many investors believe there is greater opportunity for fund managers to add value when investing in smaller companies. While the evidence indicates many managers in the small-cap category have been able to outperform the index, many individual managers have failed to maintain their level of outperformance over time.  

The key question then for SMSF investors is how to find the right small-cap fund manager. Unfortunately there is no simple answer to picking the right small-cap manager. In reality the investor must do their homework to understand the factors driving a fund’s historical performance and make an informed view of the manager’s ability to deliver that level of performance into the future. They must satisfy themselves that the investment strategies are suitable for continued performance and not just a matter of luck.

Investors can use one of the reputable investment houses such as Morningstar who continuously rate funds and they should also consider having a portfolio of fund managers with different investment strategies and less correlated returns. That way investors can periodically rebalance their portfolio to manage their risk exposure based on prevailing market conditions.

You can find a comparison of managed funds on a variety of websites such as Canstar.

Listed Investment Companies

Blending the features of managed funds and the ease of exchange trading, there are a number of Listed Investment Companies (LIC) that specialise in the small cap sector.

Like managed funds, LICs have a finite pool of investible funds. They can’t contract, and outside capped share purchase plans and dividend re-investment plans, they can’t expand without shareholder approval. While this might remove an issue for the investment manager, because they don’t have to worry about investing inflows of funds or have to keep cash on hand for redemptions, it creates pricing anomalies where the pricing of the LIC may be at a premium or discount to its NTA.

This occurs due to the absence of a market maker and, often, a lack of transparency about the actual NTA. This particularly applies to less popular or smaller LICs where a lack of trading volume can make the situation more extreme. While this can allow an investor to buy at a discount (pay “90 cents in the dollar” for an asset), there is no guarantee that the LIC will regain “fair value” over any reasonable time frame. Sometimes investors are happy to pay a premium in the belief the manager will deliver a higher level of performance over the long term.

All the previous comments around funds managers and active investment styles apply to LICs. You can find a list of listed exchange traded managed investments by category on the ASX website ASX Investment Products Monthly Update.

Next Steps

Small-cap stocks can be a rewarding trade, but the added complexity of a lack of available company research often means the best performing small-cap investors need to spend a lot more time researching and understanding the prospective investment. Even so they are at a disadvantage to professional managers who can regularly visit the companies in their portfolio and talk to management and staff - an option not open to private investors.

Therefore a less risky option for SMSFs may be to spend the time researching the fund managers within ETFs, LICs and managed funds, seeking advice regarding their track record, philosophy and current holdings. This will help form a view around which funds most closely align to the SMSF's investment ideas. Having selected one or more managers an individual can always directly own particular stocks they have high conviction in, while knowing they have a diversified enough core.

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Things you should know

This article is intended to provide general information of an educational nature only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product advice. Past performance is not an indication of future performance. Investors should consult a range of resources, and if necessary, seek professional advice, before making investment decisions in regard to their objectives, financial and taxation situations and needs because these have not been taken into account.

Taxation considerations are general and based on present taxation laws and may be subject to change. You should seek independent, professional tax advice before making any decision based on this information. Commonwealth Bank is also not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and you should seek tax advice from a registered tax agent or a registered tax (financial) adviser if you intend to rely on this information to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law.

While potential SMSF investments have been illustrated within this content they do not represent a comprehensive suite of possible investment products and services within the guidelines pursuant to the SIS Act 1993 with ATO oversight.