While there are about 2,200 stocks listed on the Australian market, more than 95% of the value is made up of the top 200 stocks by market capitalisation.
That leaves a lot of tiddlers but there’s a case to be made for the Small Ordinaries, as the relevant market index is called. That “small cap” grouping is made up of stocks that are outside the Top 50 but which are among the top 300 stocks by value, or capitalisation.
There’s a lot to be said for buying a basket of small stocks, on the reasonable premise that even if one or two in 10 turn out to be duds, hopefully a bigger proportion will turn out to more than double their valuation over your holding period.
Why invest in small caps?
Note, by the way, that you don’t buy small cap stocks for their dividend: you buy them for capital growth. Most of them are in the growth phase, or what they call the growth phase, and they squirrel most of their modest free cash back into the company rather than paying dividends.
After all, if you hold a blue chip like BHP, it’s unlikely to double in value from say $35 to $70 any time soon, but there are lots of small cap stocks that manage strong growth and which can often run up (quadruple) from say 50 cents to $2 a share.
What are the risks?
That’s the good news: the bad news is that smaller cap stocks are harder to follow than the majors, as they don’t get much media coverage.
They are also less liquid than the blue-chip stocks. That is a risk to any passive Exchange Traded Fund (ETF) focussed in that area, as ETF managers have to buy and sell stocks regularly to maintain the correct weightings in their fund. If they can’t, they run into what is called Alpha Risk, which is where the basket no longer represents what its managers said it would represent: too much of one stock and/or not enough of another.
That’s the risk in passive small cap ETFs but we’re beginning to see the emergence of active small cap ETFs (including our own, ASX:IMPQ), which have a broader remit than just following an index.
They’re not as cheap to manage as passive funds, which do just follow indices, but they do have the significant advantage that a well-informed active ETF manager can screen out suspect stocks and focus on the ones that he or she thinks have the best growth potential.