Self-Managed Super Funds are thought to be addicted to the big-four banks and Telstra Corporation for their high, fully franked yields. That is true of many, but more SMSFs are dabbling further down the market, sometimes to its lowest reaches in micro-caps.
Several SMSF trustees I know are allocating an increasing portion of their portfolio to micro-cap stocks to find the next “tenbagger” stock that increases tenfold. The thought of retirees holding micro-cap stocks, typically capitalised below $250 million, was unthinkable in years past.
Empirical research confirms that more SMSFs are investing in micro-cap or small-cap stocks. About 21 per cent of SMSF trustees planned to invest in small-cap or speculative shares over 12 months, according to Investment Trends’ April 2014 SMSF Report. That is up from 16 per cent a year earlier and 8 per cent after the GFC in 2008. The peak result was 29 per cent in 2007. The latest report surveyed 2,000 trustees.
In a survey of 1,000 SMSF portfolios of the Weekend Financial Review in August, SMSF social networking site SelfWealth found trustees with more than 10 years to retirement held about a quarter of the equity component of their portfolio in stocks outside the ASX 300.
That’s not to say SMSFs are wildly speculating on penny-dreadful stocks. Trustees I speak to approach micro-cap investing through a core/satellite portfolio strategy. The core of their equity portfolio is in blue-chip shares or, increasingly, exchange-traded funds. Micro-cap stocks or specialist managed funds are used as “satellites” to lift returns.
This strategy could also called “barbell investing”. For example, 90 per cent of the portfolio goes into defensive, low-beta sectors (to achieve the market return), and 10 per cent is allocated to aggressive, high-alpha opportunities such as micro-caps (to achieve a return above the market return).
Astute SMSFs go a step further and build a portfolio of micro-cap stocks, or use specialist micro-cap funds, and focus on high-growth industrial companies such as tech stocks, rather than explorers. For them, risk is not volatility, but the threat of a micro-cap company going bust.
One or two company failures in a portfolio of 20 micro-cap stocks, which itself is worth 10 per cent of an overall portfolio, is no disaster. And if one of two of the micro-caps double, triple or achieve famed tenbagger status, the portfolio is energised with higher returns.
I’m in two minds about this strategy. First, there is scant evidence that barbell investing provides higher returns. It can lead to higher transaction costs and is potentially tax-ineffective (if there is higher portfolio turnover). It also requires greater portfolio monitoring and ability to recover from setbacks and loss – something that probably suits a younger investing demographic.
Moreover, picking a few tenbaggers that boost retirement savings sounds great in theory, but is deceptively hard in practice. Many investors go a lifetime without finding such a stock, and others that try get burned many times along the way.
That said, some SMSF trustees will need to take more calculated risks to fund longer lifespans, or fast-track savings to fund a comfortable retirement. Many will need to accumulate assets and hold growth investments for longer, before adopting an income focus. A small, carefully designed allocation of small or micro-cap stocks has some merit.
The other problem is using traditional investments to beat the market. The vast majority of large-cap Australian equity funds struggle to outperform the market over long periods. It’s little wonder that investors are looking further down the market for higher returns.
I understand younger investors or older active investors holding micro-cap stocks directly. But for those approaching retirement, or just in it, using a managed fund that specialises in micro-cap stocks makes more sense, as does getting good financial advice about this strategy.
This part of the market requires deep expertise – professional fund managers who scour the market for opportunities and understand the nuances of micro-cap companies. Investing in a fund that might hold 40 micro-cap stocks also improves diversification and lowers risk.
More micro-cap funds are emerging to cater for this demand. It wouldn’t surprise to see micro-cap funds become an investment class in their own right this decade – much like small-cap managed funds did in the previous decade.
As with any fund, investors need to examine its investment approach, management and long-term record. Many small-cap funds invest in micro-cap stocks (outside the S&P/ASX All Ordinaries index), but have most of their portfolio in stocks ranked 101 to 300 by market capitalisation.
Specialist micro-cap funds have a much higher weighting in stocks outside the ASX 300. Some have strong, consistent performance and excellent managers. The Ausbil MicroCap Fund, for example, has an annualised return of 29.6 per cent (at October 2014) since inception in February 2010.
The BT Wholesale MicroCap Opportunities Fund had a five-year annualised return of 23 per cent to October 31, 2014 (before fees). The minimum initial investment is $25,000. BT and Ausbil look the best picks of the micro-cap managers.
Elsewhere, the Investors Mutual Wholesale Future Leaders Fund has a five-year annualised return of 11 per cent and the minimum initial investment is $50,000. Among listed investment companies, the Contango MicroCap Fund has a three-year annualised return of 12 per cent to October 2014, ASX data shows.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at November 26, 2014