I’m sure we’ll be bored stiff about the news of the PMs resignation but all I would say is that it isn’t great investment news. I personally admire Mrs. May resolve and I think her suggested deal was the best of a very bad series of options. I think it is to the shame of Ultra Remainers, Ultra Brexiteers, and The Labour Party leadership that they didn’t accept this compromise. One can accept that Mrs. May didn’t have all the personal qualities needed at this difficult hour but the systemic dysfunction is breath-taking. I didn’t vote for Mrs. May but I think the alternatives now that she has gone all look horrendous. We could have Boris as PM which I regard with abject horror. We could Mr. Corbyn who I regard with abject horror. We could have another election which could result in another dysfunctional minority government, which I regard with horror. [For Corbynites, please face facts – do you really, really think that Jeremy will be able to win an additional 50 to 60 seats? I’m clearly no fan but the odds are terrible]. Or we could even end up with a second referendum, which I also regard with horror. And to cap it all, the chances of a Hard Brexit are growing by the day – I now think its 50/50 possibility that we’ll either have a Clean/hard Brexit or a second referendum/revocation. Again, that word horror comes up.
And without wanting to sound pompous, I have a sense that my views are shared by most foreign investors who don’t have any particular dog in the game. It all smells of uncertainty, with no one having a clear plan to exit the Brexit mess. And I say that precisely because even a Clean/hard Brexit will not solve the long-term challenges of trying to rebuild a relationship with Europe. It simply postpones the inevitable hard discussions. Who has the plan? In the absence of that, I think many foreign investors will simply avoid the UK.
The Size Bias
Anyway, back to much more interesting non-political stuff. I’ve long been struck by the consistent large-cap bias in virtually all communications from wealth institutions and investment banks. One will occasionally run into comments which favor AIM stocks – for tax efficient purposes – or small-cap funds run by alpha seeking managers. Also, inevitably commentary is rife on what are for now at least newly minted small and mid-cap tech stocks but this is a derivation of the IPO ‘newbie’ and tech bias rife on stock markets, not a reflection of the interest in smaller capitalization issues. Overall, I’ve given up counting the number of small-cap research papers I’ve seen recently (none in the last few years), and I think it is fair to say that large institutions are fundamentally uninterested in anything beyond the really large blue chip large caps. This all strikes me as a paradox because if one talks to most private investors, they tend to be hugely interested mid and small cap stocks. It’s a similar story when you run into consistently successful alpha seeking fund managers who almost always focus most of their energy on mid to small caps. It’s even true when you talk to academics and strategists who speak reverentially about the size premium (the excess risk premium from smaller cap stocks). God damn it, it’s even true for quant and machine learning nutcases who willingly admit that the biggest opportunities lie outside large caps.
These market participants and observers even offer us a variety of convincing narratives which help explain their passion for anything BUT large caps. Academics will point to the higher risk of small caps which produces said risk premium. Quants will say that most mid to small caps are under-researched and boast low levels of liquidity. Smart active fund managers like Gervais Williams will even conjure up a new Slow World where globalization retreats and large caps find their profit margins squeezed. All of these narratives make absolute sense to me, but if everyone thinks that mid and large-cap stocks represent an important part of portfolio diversification, why the hell don’t they invest in them? The numbers speak for themselves and its worth having a dig around inside a paper out this week from SocGen’s cross-asset team headed by Arthur Van Slooten. The paper is called “Mutual Fund & ETF Watch: It’s a large-cap world but neglect small caps at your peril” and it examines funds flow and portfolio data using EPFR numbers, and covers a global investment pool of $14.3 trillion in the US and Europe. The key findings are:
- “Large caps reign, but the share of small caps has risen Large-cap equity funds represent a crushing 84.2% of assets under management (AuM). The share of small-cap funds is much smaller (7.8% of AuM) but has been rising since 2016. In contrast, the share of mid-caps funds (8.0%) is near its lowest point since 2010 (pie chart below). Implied asset allocation: compared to average weights since 2010, fund investors appear to be strongly overweight large caps, mildly underweight small caps and strongly underweight mid-caps.”
- “Severe outflows from small caps – the canary in the coal mine? While we are not overly worried about current outflows in general, the severe outflows from small-cap funds may be part of a different story. Despite more dovish central bank policy, European small caps have been lagging the recent market rebound. That is surprising. As a high beta segment, small caps tend to amplify general market moves, as they did on the downside in 2018 for example. In anticipation of an economic slowdown (SG forecasts a recession in the US in 2020), small caps’ failure to outperform now sends a clear signal on market liquidity risk (Invest with size)”.
The key message here is that mid-caps are significantly under-owned.
The next bunch of charts shows just how much large caps have overtaken mid-cap funds. I’m struck by how little money is now invested in mid-cap funds – at just 8% of market cap, compared to over 84% for large caps.
At this point, I think it is worth revisiting comments from a few weeks ago by Michael Horan, Head of Trading, EMEA at BNY Mellon’s Pershing. He succinctly I think laid out a key funds and momentum driven narrative/consensus about why investors like large caps so much. According to Michael, “the growth of passive and ETF investment since the Global Financial Crisis has seen unprecedented levels of capital flow into liquid large-cap stocks, shifting the industry into a pedestrian investment environment. At the same time, the soaring demand for ETF products is triggering lower liquidity in smaller stocks that do not benefit from inclusion. This is concentrating investor allocation into a comparatively small number of stocks, reducing liquidity across the rest of the market and causing artificial highs in major indices. Additionally, the implementation of MiFID II’s research unbundling has created lower company coverage on small and mid-cap stocks. This creates two problems: much lower liquidity at the smaller end of the market – which we are seeing already – and more capital into large-cap stocks. This, combined with the broader shift to passive investments and continued inflows into ETFs and index tracker funds, is artificially increasing prices and causing investors to herd into large caps”.
As I’ve already said I’m not sure I agree with this line attacking ETF funds but I do think if we lump quant, factor and passive funds in together plus closet index trackers (hugging widely understand benchmarks), we end up with a more realistic ‘villain’ – the preference for deep liquidity as part of a momentum trade. Huge sums of money need to move very fast and that means they favour deep pools of liquidity in equity markets, which favors large-cap stocks. It’s very easy for a boutique manager with a few billion to focus on mid-caps but if you are running tens of billions, mid-caps – and certainly small caps – don’t make the mark. Thus, they tend to fall off the investment radar with only strategy-based investors choosing to focus on this area.
One other key indicator. ETF AuMs. Go to ww.etfdb.com and use their screener to identify the top US ETFs by market cap. Sure there are some total market ETFs which incorporate a sliver of mid and small caps but you have to get to number 12 before you run into a mid-cap index fund. As for small-cap fund, forget it – they hardly exist in index land (for obvious liquidity reasons).