Recently, poor returns from cash, bonds and other low-risk investments, combined with a long bull market have led more people to invest in the sharemarket. 

In 2020, 35% of Australians held a direct investment in shares, with a quarter of these buying shares for the first time in the past two years. 

But while many Australians own shares, only 15% of Australian investors directly own international shares. The percentage who own small and mid-cap (SMID cap) international shares is even lower, according to Investors Mutual research.

This is partly due to the difficulty for Australians to access this part of the global sharemarket, in Investors Mutual’s view.

There are nearly 8,000 stocks available in the global SMID index. This can make it harder for investors to confidently choose stocks that can potentially outperform their peers – particularly for overseas markets where it’s more difficult to obtain detailed company information. 

These factors have led to a significant under-representation of global SMIDs in Australian share portfolios in Investors Mutual’s view, despite the potential opportunities that SMIDs offer in both diversification and performance.

[Editor’s note: Small- and mid-cap shares can potentially grow faster than large-cap shares during certain periods. However, small-cap shares can also, in aggregate, potentially have higher risk and exhibit greater volatility than the market average. Small companies, by their nature, tend to have less diversified operations than large-cap companies and fewer financial resources on their balance sheet. Some small-caps might have less pricing power in their industry and less ability to weather economic recession. Investing in global small- and mid-cap stocks also exposes investors to currency risk, if that is investment is not hedged for currency movements. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article].
 

Adding global SMID caps 

So why should Australian investors consider adding global SMIDs to their portfolio?

1. Diversification. To diversify their portfolios across geography, size and sector. 
2. Performance. Investors Mutual believes that SMIDs collectively demonstrate better long-term, relative performance than many other share classes.
3. Inefficiencies. With thousands of global SMIDs available, many are very poorly understood by investors.

Diversification

The Australian sharemarket represents around only a fraction of the total investable global sharemarket. 

Although markets are, in general, closely intertwined, limiting your portfolio to companies domiciled in Australia naturally narrows access to the huge diversity of markets, economic cycles, and underlying business drivers that operate simultaneously across the globe. 

As well as introducing greater geographic diversity, moving some of your portfolio from Australian equities into global equities increases sectoral/market diversity. 

The S&P ASX Small Ordinaries Index has a very high percentage of Materials (25%) stocks, but a relatively small allocation to Technology (7%). In contrast, the comparative global benchmark, the MSCI ACWI SMID Cap Index, has only 8% Materials, but nearly twice as large an exposure to Technology (13%). 

There are other significant differences in the comparative weightings of sectors like Real Estate, Healthcare, Industrials and Utilities as you can see in the charts below:

Source: Investors Mutual. Equity sector weightings taken from Morningstar in June 2022

Another diversification benefit that global SMID-caps offer is size. While some companies are indeed very small, other companies within the global SMID-cap universe are larger than some Australian large-cap stocks, due to the comparative size of the markets. 

Australian large caps are generally considered by Investors Mutual to be over A$10 billion. There  are currently 760 companies over A$10 billion on the MSCI ACWI SMID Cap Index. The largest company is A$90 billion. 

Relative performance

Global SMID caps have delivered better returns than large-cap shares over the past 20 years, according to Investors Mutual analysis.

The long-term performance difference is shown in the graph below. If you invested $10,000 in global SMID caps (MSCI ACWI SMID) in January 2001, by the end of April 2022 your investment would have grown to $39,309. 

Whereas $10,000 invested in the comparable global large cap index (MSCI ACWI) over the same timeframe would have grown to $26,485 – a difference of $12,824. [Editor’s note: currency movements also influence the relative performance of indices in different countries].

Source: Investors Mutual. Past performance is not a reliable indicator of future performance. 

Of course, returns for a specific time period can change significantly depending on the start and end dates selected. 

Looking at rolling returns over the same 20-year period gives a better indication of how often global SMIDs outperform global large caps (rolling returns split the period into multiple monthly increments of the same time period). 

For 1-year rolling returns over the 20-year period, global SMID caps outperformed global large caps 63% of the time, according to Investors Mutual analysis.  
 

Price inefficiencies 

Investors choose active investment managers in the hope that they will perform better than the sharemarket as a whole – that is, that they will beat their benchmark index (against which they are compared). 

Active managers have different methods of doing this – whether it’s through assessing companies by quality, value and growth prospects or how macroeconomic factors will cause different companies or sectors to outperform. 

Whatever their method, or combination of methods, active investment managers try to find companies that they think have been mispriced by the market, and so are likely to perform better in the medium to long term. 

These mispriced stocks are indicators that the market is operating “inefficiently”, as in a totally efficient market everything would be priced correctly. 

There are two key drivers of inefficiencies in a sharemarket:

1. The number of stocks in a market, and 
2. The quality of the research for each stock. 

With global SMID caps, you have nearly 8,000 companies spread across 47 countries (around half are developing countries), speaking multiple different languages and subject to a very wide array of different market forces and economic conditions.

The sheer size, and diversity, of the global small and mid-cap market makes it much more difficult for investors to develop high quality, in-depth stock research. This means that many companies are under-researched and not well understood by the market in general, in Investors Mutual view.

This is illustrated in the chart below that shows that international small caps are not as well covered by analysts. Globally, there are 3-4 times as many analyst recommendations per stock for companies in the large cap index compared to the small cap index. 

This lack of information in SMIDs potentially creates an opportunity for astute active managers to add value through bottom-up company research.

Source: Investors Mutual

Moreover, this lack of research on SMIDs can potentially create price inefficiencies that provide opportunities for specialist active managers, with the requisite skills and experience, to take advantage of. 

In Investors Mutual’s opinion, these inefficiencies, or asymmetries, are greater in global SMID caps compared to large-cap stocks.