Managed Funds vs. Passive Funds in Microcaps

Managed funds can afford to be patient

Index funds are ideal in asset classes that are large, liquid, and that can readily support substantial flows with minimal price impact. This describes large cap equities well, perhaps extending to the upper end of the small cap universe. Once we descend further down the market cap spectrum, indexing becomes problematic. A substantial proportion of the microcap universe is thinly traded, and investors trying to deploy capital regardless of price will rapidly run into issues. Their transactions have the potential to move prices significantly, forcing their investors to buy higher and sell lower. This allows managed funds to add value through patient investing, taking advantage of the spasmodic bouts of liquidity that occur in microcap names, and remaining disciplined on price.

Index funds lose out to nimbler market participants

Index funds may also lose out to market participants who front run the index. This is not nefarious or illegal – the index owners broadcast which securities will move in and out of the index well in advance of the actual trades being placed to buy or sell the affected securities. This can allow nimble investors to transact in the securities about to be included or deleted from the index before passive funds push prices up or down. This reduces the returns that would otherwise be earned by passive investors, creating an additional, implicit cost on passive investors, but one which will never appear when returns are calculated. Concurrently, this provides opportunities for active managers to capitalise on price movements derived from buying or selling undertaken for non-fundamental reasons.

Differences in portfolio construction

There can also be issues with the way that index funds construct their portfolios. Often a sampling approach is used, which means selecting a subset of the index's universe to buy, and using this sample to create exposure to the asset class without needing to buy the entire universe of securities. This may inadvertently lead passive investors to avoid some of the largest winners in the microcap universe. Conversely, they may also avoid some of the largest losers, though a decent active manager should be picking more of the former than the latter. Put another way, index funds are optimising for exposure; managed funds are optimising for returns.

Smart stock picking can pay off

Microcaps are arguably the area of the equity market most amenable to smart stock picking. This is due to a combination of illiquidity, institutional constraints, and convention, among other things. Microcaps are often perceived as being riskier by investors (we don't believe this is so, but that's a topic for another post), the majority of institutions are unwilling or unable to own them, and it can be difficult to accumulate a meaningful stake in these companies. With fewer eyes scouring the microcap market for bargains, good business selection can add considerable value for investors in a way that is difficult for active managers focused on large caps, and in a way that passive investors forgo altogether.

Managed funds and indexed funds aren’t mutually exclusive

Indexing clearly has its place in the investment world. But there are some areas, microcaps among them, where indexing may not be the most effective approach. We believe that microcaps are one area where managed funds have the ability to add meaningful value for investors through patient investing, smart stock picking, and capitalising on the price impact of mechanical trading by index funds. Despite the higher fees, skilled active managers can still deliver very strong value for investors, while providing exposure to the microcap asset class. Ultimately, it is about net returns to the investors, not fees (despite what you may have read elsewhere) and it is interesting to note that most of the best-performing equity funds in Australia over the last five years have are active Microcap Funds (including our own Microequities Deep Value Microcap Fund): (VIEW LINK)

Written by Declan McLenaghan - Microequities Investment Analyst: (VIEW LINK)