Investing in Australian mid-cap stocks offers better returns on average with a lower tracking error compared to small-cap companies according to Antares Equities portfolio manager John Guadagnuolo. The difference in maturity between small and mid-cap stocks means the latter provides much stronger compounding earnings per share.
“The small-to-mid caps space typically both provide investors very high alpha opportunities, but with the base mid-cap index providing a lower tracking error than the small-caps relative to the risk budgets that you have for the ASX 300,” he said speaking at the Investment Magazine Equities Summit in Sydney last month.
“Small cap returns trail mid caps on average, as not all of them perform particularly well, some don’t survive. Others perform very well, but they need capital, and they need capital to grow. They’re raising equity, which is diluting the growth that you’re receiving.”
Mid-cap companies typically are more mature and have better capital structures and so “you get a much stronger compounding earnings per share outcome that drives your total share return.”
They also offer value for good active management. Over the last five years, the average large cap managers produced 45 basis points of alpha per annum over their preferred benchmark, the average mid cap manager has produced 1.1 per cent over their preferred benchmark and the average small cap manager has produced 1.12 per cent over their preferred benchmark according to Guadagnuolo.
“The mid-cap index has materially outperformed the small-cap index and then you’ve got a similar alpha opportunity from a better opportunity set, which is driving better returns.”
Capacity considerations
Conference delegates also heard how capacity can impact the alpha profile of a portfolio.
Capacity is normally refereed to the ability to trade – how quickly, in what volume, and the market impact of that trade – said Geoff Warren, associate professor at Australian National University. “I would argue capacity is a much broader concept… holding constraints are often more important than the ability to trade.”
Holding constraints refer to limits that a fund manager can hold of any company. “As you get more funds under management, you can get less dollars into the smaller end of the range and that progressively narrows your universe,” he said.
The number of stocks in a portfolio is another important consideration. “A concentrated strategy of 10 or 20 stocks can be quite different to say a quant manager who’s got lots of breath as they are trying to implement an investment signal across maybe a few 100 stocks,” said Warren.
Time horizon over which the alpha is realised is another consideration. “If you’re running a momentum strategy, or you’re trading on news, then getting set quickly matters,” he said. “It becomes more likely the trading costs including market impact are going to matter.”
“If you’re a value manager or a growth manager who’s taking positions for the long run, getting set quickly doesn’t matter. Rather holding constraints are more influential for determining capacity.”
Warren said there was data to suggest value managers often have negative market impact as they tend to buy stocks “on the back foot” as the market is selling.
“The maximum potential alpha depends on the opportunities your process throws up. However, capacity issues erode that alpha as assets under management rises, specifically the combination or execution costs and limits on how much can be invested in those opportunities.”
