Morningstar today released its Sector Wrap-Up for small-cap Australian share strategies, covering 33 individual managed fund strategies accounting for about 80.0 percent of category assets, as well as three exchange-traded funds and two listed investment companies.
We evaluate funds, ETFs, and LICs at the same time to enable investors and advisers to make the most effective investment decision irrespective of investment structure or active or passive approach.
Morningstar does not charge or accept payment from fund managers to participate in qualitative research reviews.
Key findings
We gave only one of the 33 strategies the highest-possible Morningstar Analyst Rating of Gold – BT Smaller Companies. We made 23 of the 33 strategies Morningstar Medallists (Gold, Silver, or Bronze).
We upgraded three strategies – Bennelong Ex-20 from Bronze to Silver, on grounds of more favourable assessment of team strength, and Colonial First State Developing Companies and Colonial First State Future Leaders, which we moved from Neutral to Bronze because of increased conviction in their portfolio managers and their ability to produce commendable results while managing a very sizeable assets base.
We downgraded two strategies, Kinetic Emerging Companies from Gold to Silver and Allan Gray Australia Equity from Bronze to Neutral. While Kinetic remains excellent, it’s no longer as much of a standout. This reflects the very strong small-cap Australian equity peer group. Allan Gray was downgraded after the announcement that portfolio manager Simon Marais has at least temporarily scaled back his duties due to ill-health. Marais’ reduced input means we believe there are stronger options elsewhere in this highly-competitive sector.
Capacity remains a significant issue in small-caps. It’s becoming more important for small-cap fund managers to get the right balance between assets under management and ability to deliver index-beating returns. Factors such as low turnover, portfolio concentration, and willingness to invest across the market-cap all play a role.
There’s no ‘one size fits all’ solution when determining the most appropriate capacity in small-caps, but warning signs may include an increase in the number of stocks in the portfolio if the manager is struggling to put money to work, and a decline in turnover if the manager is unable to trade as frequently as historically. Another signal that a fund manager may be seeking more liquidity may be a higher allocation to larger benchmark constituents.
The investment landscape for small-cap fund managers has changed in the years since the global financial crisis. The resources sector’s weighting has more than halved since its peak, providing more opportunities in sectors such as financials, telecommunications, and consumer stocks.
This has been a key driver in neutering the so-called ‘small-cap effect’, whereby fund managers have been able to outperform the index easily by overweighting the resources sector. Active managers are likely to find it much tougher to produce impressive relative returns going forward, and the emphasis will return to manager skill rather than merely making a hefty binary sector call. We expect the next three years will reward disciplined processes and fundamental bottom-up stockpicking talent, an environment in which our Medallist-rated strategies should be able to demonstrate the skills that earned them their accolades.
Market sentiment for new listings returned with a bang during the 2013/14 financial year. Over 40 initial public offerings (IPOs) made their way onto the local bourse, the smaller end of the market at the epicentre of this activity. IPOs provide liquidity and help broaden the market, giving fund managers exposure to sectors and industries previously difficult to access. Although fund managers’ enthusiasm varied, the true measure of success for a fund manager should be ability to deliver across a full market cycle, rather than just take advantage of the ‘low hanging fruit’ that comes in an IPO-rich environment.
