Small caps: one door opens, another closes

On the surface at least, the market environment in which ING’s Emerging Companies Fund reopened last week is much the same as when the fund closed two years ago.

At the time, the fund, like a number of small cap products, stopped taking new money after filling up its allocation on the back of strong returns in the sector.

Now, with the small caps sector still performing very strongly — it returned 20 per cent per annum over the last two years — ING is looking to increase funds under management by $200 million by reopening the fund’s retail trust.

This will bring the fund’s capitalisation to $1 billion, about the same level it was when it closed two years ago.

ING executive director Ross Bowden anticipates the fund will remain open for “between one and two years” to achieve its stated funds under management (FUM) target at current growth levels.

Bowden says the spare capacity in the fund is a result of “natural attrition rather than any significant outflows since closure”, plus a 50 per cent rise in the total capitalisation of the small cap sector over the period.

When the fund closed two years ago, it represented 3.5 per cent of the total capitalisation of the small caps market. However, with the increase in the sector’s capitalisation and the fund’s drop in assets, it now represents 2.5 per cent of the market.

ING is not the only fund manager reopening its small cap funds either.

The response to of the Equity Trustees (EQT) Small Companies Fund reopening earlier this month is another indication of the sector’s popularity.

EQT managing director Peter Williams anticipates the fund will close again shortly, having achieved its target of $10 million to $15 million in new applications or $50 million in total retail FUM.

It closed last October in line with a commitment by underlying manager SG Hiscock to maximise returns by closing the fund at less than 1 per cent of market capitalisation of the benchmark index.

But despite this optimism, there are some who are questioning the future performance of the small caps sector.

Paradice Cooper analyst Jonathan Harbot says there is “no chance” its small caps fund, which has been closed for more than two years, will reopen under current market conditions.

“We have a little over $1 billion under management, and we see that as a reasonable amount of money to manage in our investment universe,” he says.

Harbot predicts the small caps sector will continue to deliver positive returns this year, but acknowledges it is unlikely they will be as strong as last year.

Navigator research manager Stuart Fechner agrees, saying last year’s 20 per cent returns in the $60 billion sector were “quite considerably above a sustainable level that’s likely to be achieved year in, year out”.

“The market is at record highs on the back of small company growth. You’d expect returns to moderate over the next 12 months to more sustainable long-term averages,” Fechner says.

Joining the chorus of caution, Perpetual chief investment officer Emilio Gonzalez is unsure whether the small caps index can maintain its returns of 20 per cent per annum over the past two years and 12 per cent per annum over the last three years.

“It’s not going to be sustained through the earnings cycle year in and year out, but rather through price/earnings expansion and higher valuations — and they’re currently at a level that there needs to be some caution about.”

Lonsec senior investment analyst Anthony Pesutto also doesn’t expect a repeat of last year’s rate of return in the “foreseeable future”, but is not predicting any run on the sector either.

“Small caps will remain an important part of a diversified retail portfolio across different capitalisation structures in the Australian equity market,” Pesutto says.

He says the recent strength of investor flows is due to a “reasonable exposure to the resources sector, and because small cap companies tend to be better insulated from the rising Australian dollar due to a greater domestic exposure”.

Assirt Research, however, is less sanguine over the short-term sector outlook, warning that a bubble is forming, with relative valuations currently testing historic highs.

Assirt Research head Simon Ibbetson told Money Management that price/earnings ratios of small caps are “trading at premiums last seen in 1996-97, which immediately preceded a total collapse in small caps”.

Ibbetson warns investors against extrapolating recent strong performance, advising them instead to lower their return expectations.

“There’s been an unusually strong rally in high risk speculative growth issues over the past 12 months, and funds with exposure to this segment have experienced strong returns — which are unlikely to be repeated,” Ibbetson says.

“A value-style bias is inherent in the small cap market, with value stocks having outperformed significantly over both three, five and 10 years.”

Against this backdrop, Ibbetson says funds that re-open are “often either in net outflow mode due to poor performance or they’ve lost mandates”.

“Funds re-open to attract new inflows as a lifeline to avoid forced reductions in stock holdings, often at discounts to prevailing market prices, further impairing the fund’s performance.

“It becomes difficult to outperform when a fund is a forced seller in the small caps space because ‘everyone else knows’ and liquidity can dry up.”

Chris Cahill, director of boutique fund start-up Quest Asset Partners, agrees that the sector is past the early stages of a bubble, although he says he’s not calling a doomsday scenario.

“However, when you see stocks going up in the space of days, as some stocks have done, there’s obviously a lot of money being squeezed into a very narrow funnel,” Cahill says.

A former AMP small cap portfolio manager, Cahill says it is “getting very difficult to justify some of the prices if you assume there’s an element of cyclicality in the industries and you value the stocks accordingly”.

“I think the sign of a bull market in the small caps sector is when the cyclical nature of stocks tends to be forgotten, and that’s what I’m seeing now.”

Cahill predicts some consolidation of funds in the sector, although he admits it’s never apparent towards the end of a bull market what exactly will trigger it.

“It might be as simple as a reallocation of money into another sector of the equity market, which then gathers its own momentum,” he says.

Perpetual plans on keeping its retail fund open indefinitely to take advantage of a “natural redemption rate” in the sector, Gonzalez says.

“We’ve no intention of closing our retail fund at the moment, as inflows are offsetting the redemptions we get from the wholesale side.”

Gonzalez says he hasn’t seen any evidence yet that small cap funds are experiencing large outflows that could cause a spate of closed funds to reopen.

“That would only occur with a sharp fall in sector returns, or if some manager has fallen out of favour, or a change in asset allocation between one sector and another.”

The strength of the recent returns is encouraging the launch of new products into the small caps space, according to Ibbetson, but most big fund managers know now that the potential for short-term returns has been tapped.

“We would certainly be somewhat cautious on further product launches in the small caps space, because it is currently so over-invested,” Ibbetson says.

In terms of sector product growth, Fechner does not foresee any let-up, expecting this growth to come more from boutique fund managers that specialise in small cap funds.

While the good times roll, he doesn’t foresee the current need for new quality small cap fund managers is something that will recede any time soon — a view Lonsec’s Pesutto echoes.

“While there’s a lot more choice in the small cap sector than in the large cap sector, successful small funds seem to fill up fairly quickly, so this is creating an ongoing need for small cap managers to bring new options into the sector,” Pesutto says.