The best way to invest in small companies?

Linton

One problem with holding small company index funds is that these small companies can be quite large.  For example, I have just checked the top 10 holdings of the MSCI UK Small Conpanies ETF CUKS,  9 of them are in the FTSE100.

Its average holding market cap is £1.8B compared with the sector average of £713M.

aroominyork

Bostonerimus1 said:

My thoughts are; why would you seek to beat an index and why would you overweight small cap? 
Overweighting in a particular area could be seen as reducing diversification and doing it in small companies will increase risk.

If you buy index funds you are missing the smallest 10% (FTSE) or 15% (MSCI) cap of the market. Buying some small caps therefore increases diversification, and in a sector which, as Prism says, generally outperforms the full market.

"... why would you seek to beat an index...". Well, boston, we all know you are a fan of keep-it-simple-indexing, and you are probably right in your approach (it has influenced me and I am grateful) but even as a rhetorical question it's a bit strange.

Bostonerimus1

aroominyork said:

Bostonerimus1 said:

My thoughts are; why would you seek to beat an index and why would you overweight small cap? 
Overweighting in a particular area could be seen as reducing diversification and doing it in small companies will increase risk.

If you buy index funds you are missing the smallest 10% (FTSE) or 15% (MSCI) cap of the market. Buying some small caps therefore increases diversification, and in a sector which, as Prism says, generally outperforms the full market.

"... why would you seek to beat an index...". Well, boston, we all know you are a fan of keep-it-simple-indexing, and you are probably right in your approach (it has influenced me and I am grateful) but even as a rhetorical question it's a bit strange.

I have to admit to being a bit cheeky with my questions, particularly asking "why would you seek to beat an index"? The answer is obvious as more return is better...right? I asked the question as it's good to think about what you want in the long term and how much risk you really need to take. You should have a plan and a goal and tailor your investing to achieve your goals with the minimum risk. People can be tempted to chase returns, at one end of the spectrum we have crypto and maybe at the more sensible end we have overweighting small cap or choosing an actively managed small cap over an index because of historical returns. It's just good to factor in the added risk and potential downside as well as looking at the potential gains. 

aroominyork

All fair enough, boston, but what about my first para about not underweighting small caps?

Bostonerimus1

aroominyork said:

All fair enough, boston, but what about my first para about not underweighting small caps?

What is underweighting? It comes down to a question of portfolio building. Obviously there are far more companies outside the S&P500 or the FTSE100 and so how should you include those. If it’s on cap weight it will be a small part of the portfolio. My approach has been to use broad cap weighted indexes like the Russell 3000 and not worry any further, but is the 3001st largest company in the US actually small?

if the OP is going to have a satellite allocation to small cap I would use an index to control costs and avoid the paralysis of choice and second guessing that often comes with active funds. Also watch out for volatility and have a plan to deal with losses as well as gains.

aroominyork

The Russell 3000 covers 96% of the investable US equity market, which gives you good small/medium cap coverage. I agree that the last 4% does not matter, but I do think people investing in a global FTSE/MSCI index fund should think about whether the other 10%/15% matters. (Edit: comparing funds on Morningstar, Vanguard FTSE All Cap Index goes deeper into mid/small caps than HSBC FTSE All World Index, so my previous FTSE=85% comment isn't fully accurate.)

I do not think chasing some extra returns in small caps is reckless. As Prism said, they have proven their worth over time. I am comfortable holding, based on Morningstar's small/medium/large grid, about 65% small/medium caps in my UK allocation and about 20% in other geographies.

JohnWinder

‘some small caps therefore increases diversification, and in a sector which, as Prism says, generally outperforms the full market.’

This is too hard for me, with differing definitions of ‘small cap’, period sensitivity of returns, national characteristics etc, but…….even if you don’t write, at least think it (maybe you did): are these higher returns coming at more risk?

A quick and dirty look at portfoliovisualizer shows me that US small cap vs total stock market gave better returns over several decades (although not during all periods within), but that the risk was higher. In fact, the risk adjusted returns, as per the Sharpe ratio were the same. I’m all for promoting better returns, but we should be clear to those listening what the risk is as well.

aroominyork

I don't think anyone would contest that the further you travel down the cap scale, the more volatile the stocks are. So, if you want maximum diversification across the stock market, how do you manage the trade-off between greater diversification and greater risk? Only buy large caps or buy the full market?

An analogy is where you add a higher risk but negatively correlated asset to a portfolio. The efficient frontier theory says that a portfolio of 75% bonds/25% equities not only has historically provided better returns than 100% bonds, but is less volatile. 

Bostonerimus1

How to incorporate small cap is a discussion that could go round and round forever. So in answer to the OP's question I'd probably do it via a multi-asset fund or a broad equity fund ie for US something based on Russell 3000. The danger with using a specific small cap fund is that you end up overweighting too much and taking on more risk than necessary. But really if the OP is going to add 5% or 10% in small cap to an already solid core, then they are really just fine tuning an already solid core so it won't matter much how they do it.

aroominyork

Fair enough, boston, but I would replace "taking on more risk than necessary" with "taking on more risk than you originally intended".