Active Managers Deliver: Evidence from the Australian Micro-Cap Sector
Foresight’s latest analysis of the Australian equity strategies reveals some interesting insights. While the big-caps have done very well over the past 10 years, Micro and Small caps have delivered negative total returns since 2007. This poor performance over the period means investors that picked active management over passive were generally well rewarded on a fee and risk-adjusted basis. This is not a surprise given how under-researched this segment of the market is.
The case for active management is quite strong, however, both fees and capacity can be an issue for many institutional investors. Still, we believe investors should not overlook the potential for high alpha (net of fees) from this segment of the market. That said, volatility and liquidity are the issues that need to be carefully addressed.
Performance statistics presented in the dashboard below clearly show the level of volatility experienced by micro-cap index (S&P/ASX Emerging Companies). For example, between 2010 and 2015, the index returns were negative for five consecutive years. A skilled active manager can help dampen this type of volatility in a micro-cap portfolio.
By their very idiosyncratic nature, micro-cap sector is less correlated with the broader market and large cap segments. The average correlation between micro-cap index and ASX All Ords was 0.44 percent over the five-year period to 30 June 2017. As expected, the correlation between small and micro-caps segments was higher at 0.78 percent. The correlation benefits can be enhanced when alpha patterns of a skilled manager is considered.
Analysis of the micro-cap manager performance by Foresight using Morningstar data-set shows strong breadth of outperformance by active managers. Of the total managers with three and five year track-records, 83% of managers beat the index over three year and 100% beat the index over 5 years for the open ended funds. This observation is also consistent for the separate account performance.
There is strong evidence that active management adds value in the Australian micro-cap sector. It is one of the few segments of the market where institutional and wholesale clients could consider allocations to active management. Volatility, drawdown, liquidity risks need to be kept in mind. Fees can be high but it is worth paying for a skilled active manager. Capacity constraints are an issue but we have observed good supply of capacity being added from new boutiques and existing managers adding micro-caps to their product suite.
Analysis of the risk adjusted returns using the Sharpe Ratio and the Information ratio shows the median manager delivered positive results. As always, the dispersion between managers is quite high. Picking an above median manager over the past three years would have delivered strong Sharpe and information ratios to investors.