Managing Risk in Small Caps

The standard industry method –Does it work well in small caps?

The standard method for dissecting risk exposure vs an index is the use of a commercial risk model, such as Axioma, that can accurately track variances in portfolio factors such as momentum, value, volatility, quality and size. Around 80% of the risk in a large cap portfolio, benchmarked against the S&P/ASX 100 Accumulation Index or S&P/ASX 200 Accumulation Index (ASX 200), can be measured and segmented using one of these models. The unexplained risk balance, typically around 20% in many large cap funds, is due to stock specific risk. However, for a concentrated small cap portfolio, such as the Eiger Australian Small Companies Fund, an industry standard risk model can only explain around 15% of the risk exposure vs the S&P/ASX Small Ordinaries Index (ASX Small Ords). The following chart highlights that between April 2019 and May 2020 the Axioma risk model we use can only explain between 12% and 22% of the risk in our portfolio vs the ASX Small Ords.

The balance, as in a typical large cap portfolio, is due to stock specific risk. However, in small cap
portfolio such as ours, stock specific risk is 80% of the risk vs the benchmark rather than 20%.

The volatility of our portfolio is higher than the ASX 200 but lower than the ASX Small Ords….

Does this make a portfolio such as ours excessively risky or volatile? We believe that the answer is definitely no. In addition, what this also highlights is that our portfolio of typically 30-40 stocks is not a portfolio that is constrained by a benchmark or any other overly restrictive factors that can inhibit performance. The Eiger Team has managed a small cap strategy continuously since April 2011. The standard deviation of daily returns (a universally accepted measure of volatility) of this strategy to the end of May 2020 is 1.019%*. The daily volatility of the ASX 200 and the ASX Small Ords over the same period was 0.99% and 1.054% respectively. Our portfolio over this time period has been less volatile than the ASX Small Ords Index and closer to the volatility of the ASX 200 that is dominated by Australia’s largest and most secure businesses such as the major banks, supermarkets and diversified mining giants.

We have also analysed longer term data from similar small cap funds published by Morningstar. For example, the UBS Australian Smaller Companies Fund between inception in March 2004 and November 2018 had a daily return standard deviation of 0.99%. The ASX 200 and ASX Small Ords had a daily standard deviation of 1.027% and 1.078% respectively over the same time period. We believe that it is possible to manage the overwhelming influence of stock specific risk in a concentrated small cap portfolio to take advantage of the high growth, innovation and entrepreneurial management and achieve a level of risk and volatility in line with the broader ASX 200.

Another way of analysing strategy volatility is to count the number of days the relevant fund’s unit price has varied above a specified amount. We have 4,123 days of observable unit price data for our small cap strategy. On 241 (5.8%) occasions the unit price has varied by more than 2%. Increasing the variance to 5% reduces the number of occasions to only 10 (0.2%). This is despite the strategy investing only in small – and mid-cap companies whose individual share prices are often much more volatile.

…but the historic returns are higher

The five year through-the-cycle track record of our small cap strategy is shown in the chart below. Despite having lower volatility than the ASX Small Ords the through-the-cycle returns have consistently been higher.

Managing stock specific risk

We have continually refined the way in which we manage stock specific risk, which as discussed typically accounts for around 80% of the total risk within our small cap strategy. We have measures in place to maintain a level of volatility below that of the ASX Small Ords, including:

1. Our research process requires us to construct our own models and forecasts rather than significantly rely on broker estimates, financial databases or consensus forecasts.

2. Our modelling template – which is largely unchanged for over 15 years – includes a significant quality bias with its focus on growth, operating cashflow and the consumption of cash via capex, working capital and intangible investment.

3. Our 9 Commandments which have been formulated over the 70+ years that our team collectively has in financial markets.

4. Portfolio constraints that include a 5% active limit on any one investment. We believe that this limit has worked time and time again in making sure that, for example, after a strong short term rise in a share price that some profits are harvested. As Bernard Baruch said over a hundred years ago “nobody ever lost money taking a profit”.

5. A proprietary fundamental reclassification of our investment universe into 25 categories. The following table charts the ASX Small Ords, which forms a significant portion of our investible universe, into these categories. We use these classifications to manage the fundamental underlying profit drivers within our portfolios. This ensures that we don’t accumulate excessively concentrated economic biases with our individual bottom up stock selections. We have continued to refine these categories for almost 10 years and believe they more fundamentally recognise economic risk than the standard Global Industry Classification Standard (GICS) classifications. The table below also highlights how significantly the sector bias has changed over time and the necessity to manage risk against these changes.

We believe that these factors are key to achieving risk and volatility well below the ASX Small Ords and more in-line with the ASX 200.