As figure 1 shows, from May 1994 to May 2010 global smallcaps have outperformed both largeand mid-cap shares in developed and emerging markets. This is in keeping with research by Banz (1981) and Fama and French (1992) which also found that small-cap shares earn higher returns relative to large- and midcap firms. The difference is in large part explained as compensation for the lower relative valuation, lower liquidity and higher transaction costs (Ennis and Sebastian, 2002) of small-cap shares. However investors should note that as figure 2 shows, this relative outperformance is not always constant. While small-caps outperformed large-caps overall for the period, throughout the tech bubble years of 1994 to 1999, largeand mid-cap shares outperformed small-caps. Do global equit y ma nag ers ti lt to sma ll-caps ? In view of the long-term small-cap premium, potential diversification benefits and the opportunity for skilled investment managers to outperform the benchmark through careful stock selection, it would be logical to assume that broad-cap global equity investment strategies would selectively invest in global small-caps. In practice it is not always possible for global equity investment strategies to hold global small-caps stocks due to capacity constraints imposed by their level of funds under management. At November 30, 2009, the average market cap of the MSCI ACWI Small Cap Index was US$552 million.
Based on this average market cap, figure 3 shows the percentage of a small-cap company’s market capitalisation that a global equity manager would hold for a given portfolio weight and a given level of funds under management (FUM). The table shows that if a global equity manager with FUM of $10 billion were to hold a 50 basis point (bps) position in the average global small-cap company (market capitalisation US$552m) that global equity manager would hold 9.06 per cent of the small company’s equity. Portfolio weights that equal more than 5 per cent of a company’s market capitalisation are shown in red. The simplistic analysis above does not take into account free-float (which in many cases is less than market capitalisation), liquidity (which is often lower for smallcap shares relative to large-caps) and the potential for the sale or purchase of large holdings to impact share prices. Substantial shareholdings must also be reported. So is it possible for a large global equity investment manager to invest in even the largest global small-cap shares? At November 30, 2009, the 10th largest company listed on the MSCI ACWI Small Cap Index was Alexion Pharmaceuticals with a market capitalisation of US$ 3.72 billion. Figure 4 repeats the same analysis as Figure 3, except that the assumed market capitalisation of the sample small-cap share is US$3.72 billion, the same as the 10th largest company listed on the MSCI ACWI Small Cap Index. Again, global equity investment strategies with high levels of assets under management may find it difficult to hold portfolio weights greater than 100 basis points in even the largest global small-cap shares. It is plausible that capacity constraints imposed by the level of funds under management, available free float, liquidity and market impact restrict the ability of global equity investment managers to invest in global small-cap shares.