Archived article

Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

The potential upsides and drawbacks to a passive approach to smaller company investing

Exchange-traded funds (ETFs) are often associated with the largest, most liquid stocks in the market, but in fact you can use them to gain exposure to small companies too.

But why would you want to hold them through ETFs, what are the risks, and what are your options when it comes to choosing a fund?

Looking at all the London-listed ETFs with at least 50% of their portfolios in small caps, you can see a mix of geographies and indices, as well as growth and value styles.

How is a small cap defined?

How a small cap company is defined will vary depending on where in the world you are looking.

In the US, for example, companies tend to be bigger, so the definition of what constitutes a small company will be much larger than its UK equivalent.

One of the issues with using ETFs to invest in small caps is that the indices are market cap-weighted, which means the total market value of a company’s shares determines its weighting within the index, and therefore how big its position in your ETF portfolio.

Because of this, you can become quite concentrated in certain markets and sectors. The MSCI World Small Cap index, for example, has 57% in the US, 12% in Japan and 6% in the UK, and has a lot of retailers and banks, plus more than 20% exposure to real estate, which you might not want in the current environment.

Avoiding the froth

Market weighting means you could also end up with a lot of fashionable stocks that have been bid up to high levels, warns Rob Burgeman, divisional director, investment management at Brewin Dolphin. ‘In some ways it’s risker to invest in small caps through ETFs because it’s a blunt tool – weightings are entirely based on market cap so you’ll naturally gravitate towards larger companies and you lose the ability to cherry pick,’ he says.

He pointed to soft drinks maker Fevertree (FEVR:AIM) – for a while it was everyone’s favourite small cap stock, going from around £4 a share in 2015 to £39 in 2018 before falling back down to £9 again.

‘It would have been a major constituent of small cap indices at that peak,’ explains Burgeman. ‘If a stock gets a bit faddy and carried away with itself, its weighting goes up and then you are going to fully participate in the downside.’

Does that mean it’s better to invest in small caps through an active fund where managers can be more choosy and avoid the froth? ‘Small cap is a space that lends itself to active management. However, it’s also true to say that there are a lot of active managers who haven’t demonstrated that they’ve added a lot of value in small caps,’ notes Burgeman.

Real cost savings?

A major argument for going down the passive route is that you can invest at a low cost. However, fund charges in small cap ETFs tend to be higher because the cost of dealing in those markets is higher, and sometimes there isn’t a huge gulf between their ongoing charges figure (OCF) and those on active funds.

If there is not a big price difference, it could be worth choosing an active manager ‘for the intellectual capital of somebody actually checking these companies and picking the ones they think are the best ones,’ advises Burgeman. ‘ETFs are not always as cheap as you think they are.’

For example, the $1 million First Trust US Small Cap Core AlphaDEX ETF (FYX) charges 0.75% and has returned 3.4% over the last three years. For the same level of fee, you could buy the smaller companies-focused Edinburgh Worldwide Investment Trust (EWI), which has 60% of its portfolio in the US and has delivered a return 114% over the same period. Or, if you wanted a more comparable fund, Artemis US Smaller Companies (BMMV576) charges a little more at 0.89% and has returned 52% over three years.

Do your homework

So what should you look for when choosing a small-cap ETF? It’s important to know what the index that the ETF tracks actually does, says Ben Seager-Scott, head of multi-asset funds at Tilney Group. ‘Research into the index is often overlooked in ETFs, some people think look at the name and that tells you all you need to know,’ he says.

‘Go online, look at the index methodology, see what they consider to be large and small companies because some can be considerably smaller than the others. Look at the makeup by region and sector, compare and contrast and make sure you understand what you are buying.’

If you wanted to invest in, say, US small companies, there are a handful of options available. Here is a quick comparison of two London-listed ones.

If you instead chose a global small cap ETF such as the iShares MSCI World Small Cap ETF, you’d have 57% exposure to the US, with smaller positions in other developed markets.

Of course, you are not restricted to either active or passive when looking for exposure to smaller companies. Seager-Scott suggests buying a mid cap ETF and combining it with a small and micro cap active fund to get a broader spread of companies while still benefiting from the size factor.

‹ Previous2020-08-13Next ›