To be(ta) or not to be(ta)...

25 Mar 2019

From time to time, the market reminds us of the inherent volatility of equities as an asset class. The December quarter of 2018 was a clear example of this, with broader Australian equities¹ falling 8.4%; its largest quarterly decline since September 2011.

In comparison, smaller companies² fared even worse, declining by 13.7%. This result was not unexpected as smaller companies have historically displayed higher beta characteristics (market sensitivity) relative to their larger counterparts.

Data Source – Zenith, Bloomberg

The beta of smaller companies and larger companies relative to the broader Australian equity market, from December 2002 to December 2018, is shown in the chart above. Large companies exhibited lower beta (0.98) relative to the broader Australian equity market, whilst smaller companies have historically been higher beta (1.16).

A beta of 1.16 implies that for every 1% increase (decline) in the broader Australian equity market, a 1.16% increase (decline) in smaller companies is expected. As such, smaller companies have historically been more sensitive to broader market movements. Conversely, larger companies are less sensitive to broader market movements.

Why are smaller companies higher beta?

The higher market sensitivity of smaller companies is generally underpinned by three main factors:

• Higher concentration of unprofitable companies
• Lower liquidity
• Lack of research coverage

It is worth noting that our analysis has derived from passive benchmarks. As such, Zenith believes these outcomes do not capture the impact of active management.

Smaller companies are higher beta, but they need not be

Although the smaller companies index has historically demonstrated a beta that is greater than 1, we have found that this has not been the case for Zenith’s rated actively managed smaller companies funds.

Data Source – Zenith, Bloomberg

The beta of Zenith’s rated active smaller companies funds as at 31 December 2018, relative to broader Australian equities, is shown in the chart above. On average, Zenith’s rated active smaller companies funds exhibited a beta of 1 or less relative to the broader Australian equity market, larger companies and smaller companies indices. This indicates that Zenith’s rated smaller companies funds have a similar or lower sensitivity to broader market movements.

We believe that Zenith’s rated active smaller companies managers have been able to achieve this outcome due to a heightened focus on factors such as valuation, profitability and liquidity.

How did Zenith’s rated active smaller companies funds fare during last year’s turbulence?

The excess returns of Zenith’s rated active smaller companies funds were subdued in the December 2018 quarter, which Zenith notes was partially driven by the majority of stocks converging and falling together, regardless of company fundamentals. As a result, it was a very difficult environment for active managers to perform well.

However, we note that Zenith’s rated small cap managers were able to generate excess returns over the 12-month period. Specifically, for the 12 months ending 31 December 2018, Zenith’s rated active smaller companies funds generated excess returns of 2.5%.

Historically, Zenith’s rated active smaller companies managers have provided significant downside protection whilst also participating fully in market upswings. Zenith believes this highlights the benefit of active management, especially in the less efficient segments of the market.

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¹ As represented by the S&P/ASX 300 Index

² As represented by the S&P/ASX Small Ordinaries Index

By Quan Nguyen, Head of Equities