“If stocks are not covered well, then there is also likely to be a general misunderstanding of the company’s business, which can lead to sharp price increases when the market realises a stock’s value.”
Active management is also critical for assessing the quality of small-cap stocks, S&P says.
“The market generally perceives small-cap stocks to be lower quality relative to their larger-cap peers,” it says.
“In determining the quality of a company, fund managers [examine] a number of factors, including a company’s financial strength, management quality, and market position. Managers need to sift through the large universe of small-cap stocks to determine which have the greater risks and are the poorer quality companies, and which are higher quality and likely to succeed.”
S&P strongly advises investors considering a global small cap exposure to take care selecting the fund they use to achieve it.
“There are a limited number of opportunities in the Australian market to gain exposure to international small-cap funds,” S&P says. “The products are diverse, each providing varying market cap, style and risk/return characteristics, so investors need to assess which is appropriate for their specific needs.”
S&P says investors should have at least a five-year time horizon when investing in a small-cap fund, “to fully capitalise on the potential benefit and ride out the ups and downs”.
Almost the exact opposite of a small-cap, actively managed fund is an exchange-traded fund (ETF) that tracks a broad market index. Such an investment isn’t going to focus in on the individual investment opportunities that Fidelity, Principal and S&P speak of; but it can give investors broad exposure to markets and sectors across the world relatively easily and efficiently, and certainly cheaply.
There are ETFs that give broad global sharemarket exposure, and which allow investors to lock in global sharemarket beta (or market return) as the core part of an international equity exposure. This core can then be supplemented with exposures to specific markets or regions, as opportunities arise.
In the scheme of things, global ETFs aren’t huge; Blackrock’s ETF Landscape report at the end of February put the assets of ETFs that give global exposure at a mere $US28.6 billion out of a world-wide ETF market size of $US1.4 trillion.
Investing in offshore ETFs presents some challenges and issues for investors – particularly investors who buy an ETF listed on the Australian Securities Exchange, but which is cross-listed on the ASX from another market.
Not least of these issues is the fact that the ETF listed on the ASX may be traded when the underlying market in which that ETF invests is closed to trading. In these cases, says Tom Keenan, a director of iShares, it’s the role of the ETF market-makers to ensure trading in the ETF on the ASX remains liquid, and that the buy-sell spread does not become too wide.
But the advantage of being able to trade, say, an ETF that tracks a broadly-based US market index even when the US market is closed is that advisers and investors can implement their global strategies in real time – there’s no need to place an order and wait for the US market to open before it’s executed.
Keenan says ETFs are also more robust than many investors give them credit for, and can be used efficiently and effectively even at times of great financial stress.
For example, he says, the Japanese earthquake and subsequent nuclear fears once again underlined that some of the thinking about ETFs is misinformed. In the week or so after the Japanese earthquake, far from ETF liquidity drying up altogether, iShares experienced trading volumes in its various Japanese ETFs between 10 and 30 times the average. This was a genuine test of the liquidity mechanism provided by market makers. Keenan says fears that ETFs would inevitably suffer a liquidity crisis after a major financial shock once again proved unfounded.
ETFs are also available for investing into emerging markets, but for the time being, at least, investors seem to be showing a clear preference for active management in these markets.
But investors are also rethinking what constitutes an “emerging” market. New research from State Street Global Advisors (SSgA) suggests that it’s “more than just a Brazil, Russia, India and China story”.
SSgA’s research shows that since January 1997, these so-called BRIC countries have underperformed smaller, less well-known emerging markets, including Chile, Colombia, Czech Republic, Egypt, Hungary, Israel, Peru, Poland, the Philippines, Thailand and Turkey.
In a paper on these findings, SSgA portfolio manager for active emerging market strategies, Chris Laine, says investors shouldn’t abandon a BRIC strategy at all, but should “not close their eyes to other growth areas in the emerging world”.
“Many of the smaller emerging and frontier economies have quietly been making investor-friendly reforms and deserve the attention of international investors. Many of these economies offer value, growth and solid profitability,” Laine says.
“The research also shows that with stocks trading at 11 times forward earnings, the broad emerging market asset class is not in a bubble.
“While it is true that emerging markets no longer trade at a significant discount relative to developed markets, it is hard to say that an asset class trading at 11 times forward earnings is in a bubble. This is right in line with its seven-year average.”
Like small caps, emerging markets are thought of as more volatile and hence more risky. However, Laine says there are reasons to think emerging markets have fundamental characteristics that make them attractive.
