Since the middle of last year, it has been widely reported that the major Australian industry funds have taken a defensive stance in allocating across asset classes. With interest rates turning lower across the world, deflation fears rising, sharply weaker energy prices and ballooning Government debt, the consultants have made two big calls. First, to de-weight Australian dollar assets, and second, to spread investable capital widely across assets.
The second call above is driven by the prevailing view that returns across most asset classes will be below historical averages in 2016. How they arrive at this view is not clear, but they probably share our concerns that negative bond yields across Europe and Japan suggest that returns from most assets will be severely challenged.
One aspect of asset allocation that has caught our attention has been the de-weighting of Australian equities. The largest funds (including the Future Fund) have taken a bet against the Australian share market and appear to have lowered their allocations to less than 50% of equity exposures. Further, they have lowered their total equity class exposure (including offshore equities) to about 40% of assets. We suspect that asset advisors are forecasting that the extreme Australian equity market bias towards financial and resource stocks will continue to effect the likely returns from the Australian index. Consequently, direct flows into the market have sharply declined and are well below historic averages. Flows via index structuring, focused on the large-caps, have given way to greater relative flows to the emerging or smaller capitalised companies (outside the ASX 200). This means that flows to small-cap fund managers have increased.
The higher allocation to small-cap managers has a few notable effects and dangers:
First, it pushes a significant amount of capital into the “small-cap index” and  creates a bias to popular or so called “emerging growth stocks”. Essentially, prices can get out of kilter with value, and small-caps can become relatively more expensive than larger stocks;
Second, it creates a herd-type mentality, as small-cap fund managers’ performance are assessed against the “small-cap” index. This will in time see more small-cap index-type investing, and defeat the purpose of identifying under-researched emerging companies. Investors should be cautious in allocating capital to fund managers who do not actively stock select in this end of the market;
Third, the allocation of excessive amounts of capital to this segment of the market will in time make it more difficult for managers to outperform. There are always dis-economies of scale operating in funds management, and scale is hit at low levels in small capitalisation investing; and
Fourth, momentum-type investing becomes a feature of a market that is expanding too quickly, and this also acts to push share prices above reasonable valuations. Short term it supports performance, but longer term it creates capital risk if prices adjust to value quickly due to disappointing news.
While we are supportive of an allocation of capital to smaller emerging companies that are able to compound their returns quicker (for a period) than larger companies, we caution against extrapolating short term financial performance into the future. Asset allocations can be adjusted over time, and if the small company index trades at a significant premium (based on PERs) to the ASX 50 index, then it will be a short matter of time before an adjustment to capital allocation is made. The depth of the small-cap market can change quickly and catch many funds unprepared.
At Clime, we monitor asset allocation models by asset consultants to gain an insight into the assessment of risk across asset markets.