By Stephen Colwell, senior investment analyst, Zenith Investment Partners

While Australian small cap funds have historically delivered outperformance against their collective benchmark at an impressive rate (85% of Zenith’s rated peer group outperformed over the last five years), since January 2022 they have lagged behind their large-cap counterparts.

In the rollercoaster ride of Australian small cap versus large cap performance, we see an intriguing pattern. There are periods of comparative underperformance followed by strong recoveries in the relative performance of our rated small-cap funds.

The secret sauce: Why small cap managers continue to deliver excess returns

There are several factors that go into the high success rate of active management in Australian small caps. One key driver is the pronounced market inefficiencies in this segment.  Unlike their larger counterparts, smaller companies stocks tend to be covered by fewer research analysts, meaning there is ample opportunity for active managers to identify mispriced stocks.

Picture this: BHP Billiton, with its colossal market capitalisation ($A 255 billion as at 31 December 2023), boasts 28 analysts scrutinising its every move, while little-known Weebit Nano ($A 803 million) flies solo with no analyst coverage.

Now, as of 31 December 2023, the average number of analysts covering constituents of the S&P/ASX 100 Index was approximately 70% higher than those covering the S&P/ASX Small Ordinaries Index. This asymmetry sets the stage for small cap managers to swoop in and uncover hidden gems.

Navigating institutional headwinds

Small cap strategies have faced a number of headwinds in recent years. Potentially the most influential has been the wave of institutional funds which have meaningfully divested from the market segment, leaving a noticeable dent, as illustrated by the decline in both institutional funds under management (FUM) and the total number of individual mandates since 2019.

he reasons behind this retreat are multifaceted. It could be due to institutions pivoting with Your Future, Your Super (YFYS) performance test measures or simply changing asset allocation decisions. Regardless of the cause, the response has led to selling pressure on small cap companies.

However, there’s a silver lining.  The outflows of institutional funds has created room for retail investors to access longstanding and well-rated small cap strategies that were previously dominated by institutions. Additionally, this indiscriminate selling may have led to further market inefficiencies that can be exploited by active management.

The initial public offerings (IPOs) drought

Initial public offerings represent a promising avenue for potential returns for small and micro-cap funds. However, there have been limited opportunities in recent times. The numbers speak volumes. Since 2021 there has been a material decline in IPO activity.

Our analysis reveals a striking statistic: there were only two IPOs larger than $A 50 million in 2022 and only four in 2023. Comparing this to the 10-year average of over 20 IPOs annually, the magnitude of the decline becomes evident. Only time will tell whether these opportunities bounce back in 2024.

Where do fund managers believe the opportunities lie?

But where do the experts see the greatest potential for returns this year? We surveyed all rated fund managers within our Mid Cap Companies, Small Companies and Micro Cap Companies peer groups, to find out.

The responses provide a fascinating glimpse into market sentiment, ranking the most attractive market segments for 2024.

Despite the localised challenges of institutional outflows and the scarcity of IPO opportunities, there’s reason for optimism. With local inflation declining and interest rate cuts seemingly on the horizon, for investors,  perhaps active small cap managers are better positioned to capitalise on opportunities in 2024.