One problem with investing in small cap trackers1 [1] is that there is no consistent definition of small. Like ancient market traders before the invention of scales and Trading Standards, some people’s idea of small turns out to be quite big.
For example, if you want to invest in UK small caps then you might consider any of the following indices:
- The FTSE SmallCap Index – the bottom 2% (i.e the smallest 2%) of the UK market.
- The Numis Smaller Companies Index [2] – the bottom 10% of the UK market.
- The MSCI UK Small Cap Index – the bottom 14%.
- The FTSE 250 Index – the 16% (or so) slice that sits below the FTSE 100 and above the FTSE SmallCap.
The disparities in size can be enormous. The largest firm in the FTSE 250 is worth £4,047 million while in contrast the big kahuna of the FTSE SmallCap weighs a mere £591 million.
Theoretically, the weenier the firms held by your index tracker, the more likely it is to benefit from a small cap boost – due to the size premium [3].
But you won’t find a tracker that follows the FTSE SmallCap, the FTSE Fledgling, or even the Numis index.
That leaves you to fish about in the active fund murk, or to compare trackers that take their lead from the beefier FTSE 250 or MSCI Small Cap indices.
Comparing small cap trackers
Firstly, drop the name of your tracker into Morningstar’s [4] search box and click through to its overview page. Click on the Portfolio section and you’ll see something like this snapshot [5]:
[6]
Compare the tracker’s Average Market Cap figure (see the red circle on the pic) versus its rivals to understand which product packs the most pygmies. The smaller the market cap, the better.
The Market Capitalisation section (green circle) gives you further insight into how the fund’s holdings breakdown into large, medium, and small cap firms.
Note, in this instance iShares MSCI UK Small Cap ETF [7] is only 28% invested in firms that Morningstar actually rates as small cap or below.
As such the Morningstar Style Box (red arrow) rates the ‘small cap’ tracker as a mid cap product. That’s because it follows the MSCI UK Small Cap Index, which smells a lot like the FTSE 250.
The final section that’s worth a shufty is Valuations and Growth Rates (blue arrow). These metrics [8] offer a small but smeary window into the fundamentals of the equities held. The lower the numbers, the more the tracker tilts towards the value premium [9].
If the numbers are low enough then the product would register a hit in the left hand column of the style box.
In other words it would be a value fund.
Historically, the sweet spot has been in the bottom left hand corner: small value returns have outperformed the other spots on the grid. The one to avoid is the bottom right hand corner: small growth [10].
Remember, just because small value funds have outperformed in the past, there’s no guarantee they won’t crash and burn in the future.
Moreover, to earn that premium, small cap value investors have at times had to endure many years of beating themselves around the head as their small cap funds plunged the depths and trailed the market. Such is the price of reaching for higher returns.
Although I’ve only discussed UK small caps so far, the same principles apply to any region’s small cap offerings. You can use this system to compare the small cap chops of active funds, too.
Naturally, kicking the tyres like this doesn’t mean you’ll pick next year’s best performing fund. But it does mean you’re marrying up the academic evidence with publicly available data to give yourself a good shot of earning decent long-run returns.
A small cap hitlist for UK passive investors
Here’s a handy selection of small cap trackers and the occasional active small cap funds, organised by asset class:
| Global Small Cap Funds | Index | Average market cap (£ mil) | OCF (%)2 [11] |
| Vanguard Global Small Cap Index Fund | MSCI Small Cap World | 1,340 | 0.4 |
| SPDR MSCI World Small Cap ETF | MSCI Small Cap World | 1,608 | 0.45 |
| Dimensional Global Targeted Value Fund | N/A | 1,440 | 0.66 |
| Dimensional Global Small Companies Fund | N/A | 1,096 | 0.6 |
- Global usually means developed world.
- The Dimensional funds don’t follow indices but use a passive methodology.
- Dimensional funds are only available through qualified IFAs.
| US Small Cap Funds | Index | Average market cap (£ mil) | OCF (%) |
| db x-trackers S&P 500 Equal Weight ETF | S&P 500 Equal Weight | 12,006 | 0.3 |
| db x-trackers Russell 2000 ETF | Russell 2000 | Not available | 0.45 |
| iShares S&P SmallCap 600 ETF | S&P SmallCap 600 | 905 | 0.4 |
- Equal weighted funds aren’t true small cap funds. Instead they overweight smaller companies in a broad market index because they invest equal amounts into every constituent stock, regardless of actual market capitalisation.
| Europe Small Cap Funds | Index | Average market cap (£ mil) | OCF (%) |
| Ossiam STOXX Europe 600 Equal Weight ETF | STOXX Europe 600 Equal Weight | 6,197 | 0.35 |
| db x-trackers MSCI Europe Small Cap ETF | MSCI Europe Small Cap | 1,534 | 0.4 |
| PowerShares FTSE RAFI Europe Mid-Small ETF | FTSE RAFI Developed Europe Mid-Small index | 1,530 | 0.5 |
- The PowerShares index does not rank companies by market cap (as traditional indices do) but by fundamental metrics [12] that give the ETF a value-ish tilt.
| UK Small Cap Funds | Index | Average market cap (£ mil) | OCF (%) |
| HSBC FTSE 250 Index Fund C | FTSE 250 | 2,018 | 0.19 |
| iShares MSCI UK Small Cap ETF | MSCI UK Small Cap | 1,555 | 0.58 |
| Aberforth Small Companies Fund | Numis Smaller Companies | 486 | 0.85 |
| Dimensional Small Companies Fund | N/A | 1,520 | 0.66 |
- The Aberforth Smaller Companies fund is an active product with a mandate to beat the Numis index. It also has a near identical (but slightly cheaper) investment trust twin.
| Emerging Markets Small Cap Funds | Index | Average market cap (£ mil) | OCF (%) |
| iShares MSCI Emerging Markets Small Cap ETF | MSCI Emerging Markets Small Cap | 462 | 0.74 |
| SPDR MSCI Emerging Markets Small Cap ETF | MSCI Emerging Markets Small Cap | 531 | 0.65 |
| Dimensional Emerging Mkts Targeted Value3 [13] | N/A | 837 | 0.97 |
Note: All table data researched in July 2014.
The small print
It’s easy to read the evidence [14] for historical small cap and value returns and to feel a little giddy with excitement. Especially because these asset classes have performed extremely well over the last few years.
Yet that very success has raised valuations well beyond their historical averages. That’s a situation which often portends a period of underperformance.
Before you dive in, remember that investing in the return premiums [15] is a long-term game that requires a steady hand and stout heart.
Take it steady,
The Accumulator