Article
Investments in small-cap equities offer attractive return opportunities over the long term thanks to the risk premium. Adding an ESG¹ filter can reduce the risks associated with the asset class. No wonder, that small caps have evolved into an important pillar of asset allocation. Read on to find out why small caps could also be a good fit for your portfolio.
April 20, 2021
Small caps have posted an impressive performance in recent years. Just ten years ago, there was still limited demand on the part of Swiss investors for small-cap exposure. Above all, this was due to their low market volume and weak trading activity. Fast forward to today, however, many investors consider this asset class to be an important pillar of strategic asset allocation. This is evidenced by the growth in assets under management in our Credit Suisse Index Funds (CSIFs) (see Chart 1). Since the first CSIF Small Cap was launched in 2013, assets under management have seen a steady rise to over CHF 3.5 billion. What is the reason for the growing interest in small caps?
Chart 1: Asset growth of Credit Suisse Index Funds Small Cap
To begin with, the share of small caps in total market capitalization has long been underestimated. However, a closer examination of the equity market over the years shows that the share of small caps has long exceeded 12% and is therefore almost as high as that of mid caps (see Chart 2) or on a par with the share of emerging markets in the MSCI All Country World Index.² It therefore makes sense not only to focus on broad-based investments in large and mid caps, but also to give appropriate consideration to small caps.
Chart 2: Market capitalization of MSCI World Investable Market Index (IMI)
1. Exposure in line with the overall market, not only to mid and large caps, as is common practice; this also avoids an unintended bet against small caps
2. Long-term outperformance thanks to small-cap risk premium
3. Increased diversification of equity portfolio
In addition, empirical results show that – thanks to a well-documented small-cap premium – small caps generate an additional return versus mid and large caps over the long run³ (see Chart 3). Small caps have consistently gained ground on mid and large caps since the 2008/2009 financial crisis.
Last but not least, incorporating small caps broadens a portfolio’s diversification by 4,303 additional stocks⁴ and thus minimizes the idiosyncratic (or unsystematic) risk.
Chart 3: Performance of MSCI World Small Cap Index vs. MSCI World Index
For chiefly structural reasons, the small-cap segment is exposed to higher risks than large or mid caps. The business processes of small companies tend to be less stable and less scalable. In addition, risks are often neglected due to a strategy focused on growth. This structural disadvantage is readily discernible in the ESG rating distributions and average ESG ratings: The MSCI World Small Cap Index had an ESG score of 5.1 (equivalent to a rating of BBB) as of December 31, 2020. The MSCI World Index, on the other hand, achieved a score of 6.1 (equivalent to a rating of A) (see Chart 4).
Chart 4: ESG rating for small and large caps
For most of our sustainable equity funds, we use the firmly established ESG Leaders approach from index provider MSCI. The broadly diversified indices cover all regions and exhibit risk/return profiles that are comparable to their parent indices. This is mainly due to the two-stage method: In a first step, companies with significant income from controversial activities or business practices (e.g. arms trading) are systematically excluded. The remaining companies are subject to a detailed analysis based on publicly available data. This analysis results in the MSCI ESG rating. In a second step, a so-called best-in-class approach is applied, where the top 50% of companies in terms of ESG rating are included in the ESG Leaders Index. In the case of small caps, around 25% are excluded in the first step based on their market capitalization. By comparison, this figure is just 10% for mid and large caps (see Figure 1).
Figure 1: Application of the MSCI ESG Leaders methodology: large and mid caps vs. small caps
1. Comparable return
2. Low tracking error: neutral in terms of sector and region
3. High ESG exposure: exclusion of low-valued equities and best-in-class selection
When rating small caps, why doso many companies get excluded already in the first step? One frequently cited argument is insufficient or incomplete data. This is only partly true. When external rating companies such as MSCI are unable to find data on certain ESG topics (because smaller firms are less transparent) this can lead to gaps in the overall picture and thus to a lower overall rating. Therefore, in certain situations, smaller firms are not covered by data providers at all. However, the ESG data gathered by MSCI has grown to cover almost 95%. The greatest challenge remains Japan, where around 25% of data are still missing, although the scope of coverage is increasing here too. Accordingly, most companies do not fail to make the grade due to insufficient data, but rather primarily because they do not rank in the top half of ESG performers or because their ratings are too low. What is more, many specialized small caps are active in controversial business areas and are therefore excluded from sustainable strategies more frequently than larger companies
The approach taken by MSCI therefore creates a robust Small Cap ESG Leaders Index that serves as a basis for our new CSIF: CSIF (CH) Equity World ex CH Small Cap ESG Blue.
MSCI World Small Cap ESG Leaders Index: attractive return and low tracking error
Applying the MSCI ESG Leaders methodology likewise results in a lower tracking error for the MSCI World Small Cap ESG Leaders Index against the standard index (see Chart 5). Comparing the performance of the two indices additionally reveals that the return has developed practically in the same way with a comparable exposure to risk. The slight underperformance over the past two years is mainly due to the exclusion of certain biotech firms with very good results in the final months of last year.
Chart 5: Performance of MSCI World Small Cap ESG Leaders Index vs. MSCI World Small Cap Index
Small cap indices are characterized by their high number of stocks with even distribution in terms of weighting. For this reason, it is important to preserve this uniformity when buying and selling stocks in order to replicate the benchmark as closely as possible. The empirically based tracking error figure can be a good indicator of a portfolio’s ability to replicate the index. Given the large number of stocks in the index, however, the sum of all idiosyncratic risks (the sum of all individual deviations) can present a not inconsiderable risk.
For a good example of idiosyncratic risk, look no further than the massive fluctuations exhibited by the US stock Gamestop (US36467W1099) at the beginning of 2021. A slight underweight of just one basis point on January 4 would have translated in the interim (January 27) amid a universe of 4,300 stocks to underperformance of 20 basis points versus the MSCI World Small Cap Index. However, thanks to our long-term experience with this specific approach, the stock weighting in all of our portfolios matched that of the benchmark at all times.
More interesting insights about sustainable investing are just one click away.
In this area as well, investors can benefit from the long-standing experience of the experts at Credit Suisse Index Solutions. Our tracking-error-based optimization approach, which takes into account idiosyncratic risks as well as sometimes reduced liquidity, extremely low trading costs, an in-house execution desk, and dedicated corporate action handling are just some of the benefits we offer to ensure perfect index replication.
A new fund to complement our product range
The CSIF (CH) Equity World ex CH Small Cap ESG Blue replicates the MSCI World ex CH Small Cap ESG Leaders Index. With this fund, investors save on tax because it invests 20% in our CSIF (IE) MSCI USA Small Cap ESG Leaders Blue UCITS ETF, and Irish ETFs pay withholding tax of just 15% instead of 30% on US dividends compared with index funds.
If you would like to benefit from the advantages that are offered by small caps and are considering incorporating them, our index funds can help you minimize risks such as sharp price fluctuations. With the launch of the new index fund, we are taking another targeted step to expand and complement our ESG product offering. This will grow our ESG range to a total of 24 funds and further solidify our position as a leading provider of sustainable index funds in Switzerland.6
In April, we will also be launching a Small Cap Pension Fund Plus. This fund will exclusively be available for institutional investors. The Small Cap Pension Fund Plus is exempt from tax at source for Swiss pension funds on dividends issued by companies based in the US and Japan. In the near future this exemption will also likely apply to dividends from Canadian companies.
General risks of index funds
The product’s investment objectives, risks, charges, and expenses, as well as more complete information about the product are provided in the prospectus (or relevant offering document) which should be read carefully before investing.
Fund newsletters provide regular updates from fund managers and interesting insights into asset classes and themes.
1 ESG stands for environmental, social, and governance. The term has also established itself in the financial sector as the basis for assessing how sustainable an investment is.
2 Share of emerging markets in MSCI All Country World Index: 13.5% as of 31.12.2020.
3 E.g.: Fama and French (1993), Lakonishok, Shleifer, and Vishny (1994), Dichev (1998), Vassalou and Xing (2004), Liu (2006), Zhang (2006).
4 Investment universe of MSCI World IMI Index as of 31.12.2020.
5 The securities mentioned on this page are meant for illustration purposes only and are not intended as a solicitation or an offer to buy or sell these securities.
6 Source: Morningstar as of 30.01.2021.
Past performance and financial market scenarios are not reliable indicators of future performance.