International small caps due for a downturn

By Ross Kelly

AUSTRALIAN investors should reduce their allocation to small cap international equities to no more than 5 per cent of their portfolio, despite small caps outperforming large caps globally for the past three years.

The recommendation comes from a report by research house vanEyk, which also criticised the lack of competitive international small cap managers in Australia.

“The conditions we are entering are exactly the type of environment where smaller cap returns tend to be less favourable than their larger cap counterparts,” van Eyk analyst Jerome Lander said.

“Smaller companies are lower quality than the larger stocks, so they tend to underperform if economic growth decelerates.”

Lander’s comments correlate with the opinions of leading economic analysts, who have suggested that economic growth in America, Europe and parts of Asia will slow in 2005.

The van Eyk report also suggested that because the volatility of global small cap returns has been very low, an increase in volatility can be expected in the future.

Lander added that current valuation levels of the global small caps sector were “not favourable”.

He therefore recommended that investors reduce their exposure to global small caps to no more than 5 per cent of their portfolio, although he admitted that for many investors this percentage would be too small to implement in practice.

The van Eyk report stopped short of suggesting Australian investors pull out of the asset class altogether, with Lander stating that global equities give investors exposure to a more diversified range of stocks.

He said Australians don’t get access to a more diversified range of managers in the sector because most small cap managers like to focus on the region they are based in.