AFR ETF series: small caps

Australian Financial Review, Smart Money

Several exchange-traded funds (ETFs) now offer you the chance to invest in indices of small companies, both in Australia and in the USA. It’s an interesting sector, with arguments for and against playing it in a passive way.

First, the products. In Australia, State Street Global Advisors offers the SPDR S&P/ASX Small Ordinaries Fund, which seeks to replicate the Small Ordinaries Index – a basket of the S&P/ASX 300 index, minus the 100 biggest stocks. The iShares S&P/ASX Small Ordinaries ETF is based on the same index. Also in Australia, Vanguard – long known for its index funds but now a player in ETFs too – offers its own fund based on another index, the MSCI Australian Shares Small Cap Index, which includes smaller Australian companies who between them cover about 14% of the total capitalisation of the Australian stock market. Both indices include about 200 stocks.

Internationally, iShares offers a number of ETFs based around international small caps. One is the Russell 2000 ETF, which follows a well-known index covering small cap stocks in the USA. Where the Small Ords in Australia is the top 300 minus the top 100, the Russell 2000 is the top 3,000 minus the top 1,000. In practice, this means that no stock accounts for more than 0.4% of your total exposure (the top holding, if you’re wondering, being Riverbed Technology Inc, an IT company specialising in WAN applications).

It also offers the S&P SmallCap 600, which includes stocks with a market capitalization between US$300 million and US$1 billion, with adjustments made for liquidity and sector representation. In this index, the largest holding accounts for 0.85% of the market and is a group called Regeneron Pharmaceuticals. And there’s a mid-cap index fund available too: the MidCap 400, another S&P index, this time based on companies with a market cap between US$1 billion and US$4 billion.

So that’s the available field. But the bigger question is: are small caps a suitable area to use a passive product like at ETF? Active fund managers argue that small caps are exactly the sort of area where you should not be passive and follow an index. Small caps are where you want fund managers doing company visits, kicking the tyres, and finding the gems amid the rough.

Frank Henze, head of SPDR ETFs in Asia Pacific for State Street, sees things differently. “We are here not so much in competition with active managers, but giving a different service,” he says. “The rationale is that an ETF is an easy to use, low cost access to an asset class. It is controlled through a transparent and open methodology.” Depending on their point of view investors can go passive, active, or both.

At iShares, To Keenan makes a similar point. “It comes back to the proposition that an ETF brings:  a liquid, cost-effective way to an allocated to a certain part of the market,” he says. “For Australian investors, if they are building a portfolio of listed stocks, it tends to be very overweight the large-cap part of the market: it’s usually made up of a selection of the top 20 stocks, or at most the top 50. An ETF allows an investor to easily implement diversification into the small cap part of the market, buying and selling it in the same way as an individual stock.” Small caps are a volatile part of the market, he says, which can be smoothed with a diversified ETF.

Small caps are an interesting area to look at the debate about physically-backed versus synthetic ETFs. Almost all ETFs in Australia are backed by the constituents of the index they represent: the providers hold the underlying shares. But overseas it is becoming more commonplace to have ETFs where the provider does not hold those underlyings, but replicates their performance through derivatives. Sometimes this is unavoidable – a fund manager can’t hold thousands of barrels of oil, for example – but there is a debate as to whether it should happen with share-based funds. And small cap funds tend to have a much larger pool of underlying securities underpinning them – 2,000, in the case of the Russell index (for which, oddly, Russell itself does not yet offer an ETF in this country).

“The management of the liquidity of small cap ETFs is very critical, because the liquidity of the underlying is not as high as it is in the large cap part of the market,” says Keenan – that is, small stocks trade less than large ones do. “Investors need to understand the differences in the liquidity provided by small cap ETFs, because there will be differences.”