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Forget about trying to pick the next hot small stock; a smarter strategy has been choosing top small-cap fund managers that, collectively, have easily outperformed their benchmark index. But after several years of strong gains, fund researchers suggest the great bull run in small-cap funds could be slowing.

In its excellent small-cap fund review released this month, Morningstar found only one of 35 small-cap fund managers it surveyed failed to beat the Small Ordinaries Accumulation Index over 10 years to August 31, 2013. Each fund outperformed the index over five years.

The performance is more remarkable when compared with large-cap funds. Nearly 68 per cent of Australian retail equity funds failed to beat the S&P/ASX 200 Accumulation Index over three years to June 30, 2013, according to Standard & Poor’s mid-year 2013 SPIVA report. In contrast, 89 per cent of Australian equity small-cap funds outperformed the S&P/ASX Small Ords over three years, with many delivering stellar returns.

The highly regarded BT Smaller Companies Wholesale Fund has a five-year excess annual return over its benchmark index of 11 per cent, according to Morningstar. The NovaPort Premier Small Companies Fund delivered almost 16 per cent above its benchmark index over five years, and Penganga Emerging Companies outperformed by 11 per cent.

The message is clear: highly ranked small-cap Australian equity funds have consistently delivered high returns above their benchmark index. Investors who leapt for small-cap index funds, such as exchange-traded products, missed out on significant outperformance in this segment.

Moreover, small-cap funds offer diversification benefits compared with holding a handful of small-cap stocks directly, and have helped portfolio investors to achieve “alpha” (a return above the market return).

In fact, the collective underperformance of large-cap Australian equity funds, and outperformance of small-cap funds, has strengthened the case to use index products for large-cap exposure and portfolio beta, and actively managed small-cap funds for alpha.

That’s the good news. The bad news is that some factors that have underpinned small-cap outperformance are unwinding. The biggest is the poor performance of the resource sector; avoiding mining stocks over the past five years has been a sure-fire way for small-cap fund managers to outperform.

The basic materials sector accounted for 42 per cent of the Small Ords in 2010. After the thrashing of mining stocks in the past few years, the sector now accounts for about 22 per cent of the index. Many small-cap funds have a natural bias to invest in profitable industrial companies, so the underperformance of the resource sector worked in their favour.

A less considered factor is whether there will be as many performance “free kicks” for small-cap funds in the next few years: large allocations in heavily discounted placements for small companies or generous priority allocations in hot Initial Public Offerings, for example.

The trend to have ‘cornerstone’ investors – that is, a few small-cap funds take up the bulk of a small-cap IPO allocation – will make lifer tougher for funds that do not get stock in hot floats. Bigger discounts in small-cap fund raisings compared with their large-cap stocks have arguably boosted small-cap fund performance.

Another interesting trend is large-cap Australian equity funds investing further down the market in search of excess returns, such is the rising weighting of the top 10 stocks in the ASX 200 index. I have heard about several large-cap funds investing in smaller floats in the current IPO cycle.

Moreover, small-cap industrial stocks are fully valued, in my opinion. The average Price Earnings (PE) multiple in the Small Industrial Index was 15 at September 30 – in line with industrial stocks in the ASX 200 index, even though small caps historically trade at a discount. This, too, could make it harder for small-cap funds that specialise in industrial companies to outperform.

Morningstar wrote in its Australia Small Companies Sector Wrap-Up: “The future performance drivers for Australian small caps are likely to be very different from what they have been over the past three years. Small resource stocks have fallen a long way from their peaks and their percentage weight in the index has fallen with them. Therefore, even if the environment for the Australian resource sector remains subdued, the relative performance kicker for fund managers from just avoiding mining stocks will be much less.”

So should portfolio investors reduce their exposure to small-cap equity funds? The easy answer is no, given that a “long tail” market such as the Australian Securities Exchange, which has almost 2000 under-researched mid-, small- or micro-cap stocks, will always offer pricing inefficiencies for those who know where to look. And Australia has several excellent small-cap chief investment officers.

However, investors should recognise consistently strong outperformance from small-cap equity funds could be harder to achieve in the next few years, meaning even more focus is needed to identify the best managers.

Note that small-cap funds should only ever have a supporting role in most portfolios to juice up returns, with most funds allocated to the other asset classes. Determining whether there is an overlap between stocks held in large-cap and small-cap funds is also becoming more important. Investors can unwittingly reduce diversification by holding funds that own similar stocks.

The BT Smaller Companies Fund, NovaPort Premier Smaller Companies Fund, Schroder Australian Smaller Companies Fund, Bennelong Avoca Emerging Companies Fund and Australian Ethical Smaller Companies Fund, had ratings upgrades from Morningstar. The BT Small Companies Wholesale and Kinetic Wholesale Emerging Companies Funds were the only gold medallists in Morningstar’s fund review.

Long-term outperformers such as the Celeste Australian Small Companies Fund, Eley Griffiths Group Small Companies Fund, and Pengana Emerging Companies Fund also rated highly. Among newer funds, the well-managed Bennelong Avoca Emerging Leaders Fund achieved a silver rating – a strong result given it has only been going a few years and correctly called the mining downturn.  

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis are at December 11 2013.