The case for global small-cap equities in Australian balanced portfolios

Transcription

1 TOPIC PAPER APRIL 2016 The case for global small-cap equities in Australian balanced portfolios Duncan Hodnett Director of Institutional Business, Australia Eaton Vance Nigel Douglas CEO Douglas Funds Consulting SUMMARY The equity allocation in Australian Superannuation Funds is changing. As the aggregate pool of assets grows through mandatory contribution, allocators have to consider moving greater exposure outside Australia. This has been led mostly through global large-cap or global all cap investment strategies. In this paper we present evidence that a dedicated allocation to global small-caps is a real opportunity. We conduct analysis to see the effect of adding Global Small-Cap exposure into an existing diversified portfolio to understand what impacts there might be from overlap on regional and sector exposures and the differences versus the Australian equity market. Importantly we attempt to assess, on a range of metrics including Sharpe ratio, Active Share, correlations, volatility and potential alpha, what investors might expect in taking on dedicated global global-cap exposure.

2 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 2 Executive summary While Australian investors tend to be familiar with global equities including small-caps and emerging markets, this paper highlights current analysis which shows that a standalone allocation to global small-caps is attractive from a strategic asset allocation perspective relative to other asset classes in a typical diversified portfolio. There is a definite opportunity for active managers to add value given the breadth of investment opportunities and persistent excess returns evident over the last years. Investors have a large opportunity set available in the global small-cap sector over and beyond local small-caps and global large-cap equities. For developed countries, a commonly used index is the MSCI World Small-Cap Index ex-australia ( MSCI WSC ) which at AU$6.4 trillion 1 is around 13% of the total listed global equities market which totals AU$49.3 trillion. There are currently 4,191 stocks in the index which indicates the vast number of possible investments available. The MSCI WSC universe provides investors with diversity at both regional and sector levels. For example, MSCI WSC currently have proportionally larger weights in industrials, financials, materials and consumer discretionary. MSCI World Large-Caps have major weights in consumer staples, energy, healthcare and telecom services. Over the last 15 years, compared to other asset classes (in AUD terms), global small-caps have been less volatile and generated better returns than Australian small-caps and global emerging markets equities (in particular), recorded significantly higher returns than global large-caps while returns were a little lower than Australian Equities (large-caps) with marginally more volatility. In recent years, the sharp decline in the Australian dollar has enhanced the returns of global developed market equities (large and small-caps). Based on the conservative assumptions and conventional mean variance asset allocation modelling conducted by specialist researcher Heuristic Investment Systems 2 the recommended strategic asset allocation weight would be up to 5% (allowing for dividend imputation where appropriate). A significantly larger allocation would tend to add unwanted volatility to the theoretical balanced portfolio. The alpha (excess return) potential for global small-cap equity managers is such that it suggests that higher quality active managers are likely to generate sufficient risk-adjusted excess returns to justify typical base fees. In identifying suitable managers, attention needs to be paid to factors such as liquidity management, sector and macro risk positioning (especially relative to the investors other sector holdings), stock quality and currency management. 1 Source: MSCI at 29/1/16 2 Based in Melbourne, Australia

3 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 3 The global small-cap equities market Australian investors have a strong familiarity with domestic small-caps, perhaps less so with the size and opportunity in global small-caps. This section provides a summary of basic facts supported by current data. There are different definitions of what constitutes the global small-cap equities market. In contrast, Australian large-caps and small-caps are very small compared to the total. Australian large-caps (S&P/ASX 200) are AU$1.4 trillion or 2.8% of the total while Australian small-caps (ASX Small) are just AU$174 billion, 0.4% of the total 5. Global Developed Equities Universe Market Cap AUD $49.3 trillion In terms of the size of the global small-cap ( capitalisation ) universe there are a range of definitions which are reflected in the cut-offs used for maximum company size in various listed market indices. These range from US$2 billion up to US$5 billion. In choosing the appropriate market capitalisation cut-off, this depends on how wide an investment spectrum that the investor prefers and the extent of overlap with large-cap stocks. This means it makes more sense to choose the same index provider for both large and small-caps. ASX200 3% MSCI World Small-Caps 13% Aus Small Ordinaries 0.4% MSCI World Large-Caps 84% For developed countries, a commonly used index is the MSCI World Small-Cap Index ex Aus ( MSCI WSC ) which at AU$6.4 trillion 3 ) represents about 13% of the total listed global equities market which totals AU$49.3 trillion. For MSCI WSC there are currently 4,191 stocks in the index which indicates the vast number of possible investments available. The complementary developed countries large-cap index is the MSCI World Large-Cap Index ( MSCI WLC ) which accounts for 84% of the total universe. In this index, there are currently only 1,581 stocks listed. Note that even if the broader MSCI All Countries World Small-Cap Index ( MSCI ACWI SC ) is used there is relatively low overlap with large-cap emerging market indices at lower company capitalisations. According to analysis by AMG Funds, less than 3% of stocks overlap under a market cap limit of US$2 billion and with an estimated less than 16% with a market cap limit under US$5 billion 4. Source: MSCI, IRESS, 29/1/16 Source: Heuristic Investment Systems (HIS) Adding global small-caps to a portfolio provides diversity relative to both global large-caps and Australian small-caps. It is useful to compare sector and regional weightings to show how global small-caps can add diversity to investor portfolios beyond global large-caps and Australian small-caps. Firstly, MSCI WSC currently have proportionally larger weights in industrials, financials, materials and consumer discretionary. MSCI WLC have major weights in consumer staples, energy, healthcare and telecom services. 3 Source: MSCI, IRESS at 29/1/16 4 Source: Affiliated Managers Group 5 Source: Heuristic Investment Systems Estimates

4 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 4 Table: Sector Weighting MSCI World Large and Small-Caps Countries \ Sectors World World SC Energy 6.31% 3.26% Materials 4.18% 6.57% Industrials 10.63% 17.44% Cons. Disc % 15.18% Cons. Stp % 4.90% Health Care 13.28% 10.06% Financials 19.97% 24.75% IT 14.29% 13.20% Telecom Services 3.61% 0.97% Utilities 3.42% 3.67% The differences are highlighted in the following chart: Sector Weightings: World Small-Caps minus World Large-Caps Utilities Telecom Services IT Financials Health Care Consumer Staples Consumer Discretionary Industrials Materials Energy Secondly, MSCI WSC, compared to large-caps, currently have proportionally larger weight in Japan and Pacific ex Japan and less in the US and Europe. Regional Weightings: World Small-Caps minus World Large-Caps USA Pacific ex. Japan Japan Europe Thirdly, comparing MSCI WSC with the sector weightings in Australia s small ordinaries index shows Australia proportionally has over-weightings in materials, consumer discretionary and to a lesser extent telecoms. Sector Weightings: Australia minus World Small-Caps Utilities Telecom Services IT Financials Health Care Consumer Staples Consumer Discretionary Industrials Materials Energy Overall, the developed countries MSCI World small-cap equities universe provides investors with diversity at both regional and sector levels.

5 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 5 2. Performance of the MSCI global small-cap index Moving beyond the descriptive analysis of the previous section, this part of the paper focuses on factors driving the performance of the global small-cap equities sector. Historical performance (absolute and relative) of the index Over the last 15 years, compared to other to other asset classes (in AUD terms), global small-caps have been less volatile and generated better returns than Australian smallcaps and global emerging markets equities (in particular). They have also recorded significantly higher returns than global large-caps while returns were a little lower than Australian Equities (large-caps) with marginally more volatility. Asset class: Risk-Return Profile ( ) Annualised 15 year return Aus Cash Global Bonds Global Small-Cap (AUD) Aus Bonds US Credit (HY&IG) (AUD) Aus Equities A-REITs Global LC (AUD) Standard deviation of monthly returns Aus Small-Cap EM (AUD) Looking more closely at the return performance of developed markets large and small-caps compared to the Australian counterparts, the table below compares relevant indices in AUD and USD terms. Over the last three years, the performance of global small-caps and large-caps has been enhanced by the decline in the Australian dollar. Nonetheless, over 15 years, global small-caps have outperformed global large-caps though in AUD terms. However, global small-caps have lagged Australian large-caps (ASX 200). Small-Cap Equities Performance 1 year % chge 3yr return pa 5yr return pa 10yr return pa 15yr return pa 20yr return pa ASX 200 Accumulation ASX Small Ords Accum (Ex 100) MSCI World ex Aus Small-Cap Index (USD, net) na MSCI World ex Aust (USD, net) MSCI World ex Aus Small-Cap Index (AUD, net) na MSCI World ex Aust (AUD, net) Source: MSCI, IRESS, Heuristic Investment Systems (HIS), 29/1/16

6 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 6 Over time, global small-caps have persistently outperformed global large-caps, particularly as the global equities bull market commenced after the global financial crisis in March Note that there was a period of significant underperformance during the tech boom period of Global Small-Caps relative to Large-Caps performance since 1992 Global Small-Caps relative to Global Large-Caps performance since Dec MSCI World ex Aust, price, AUD MSCI World ex Aust Small-Cap, price, AUD MSCI World ex Aus Small-Cap USD price Source: MSCI MSCI Small-Cap ex Aust rel MSCI World ex Aus (USD,price) The outright performance of the equities sectors are shown in the next chart with the currency impact shown for global small-caps (as shown in both AUD and USD terms). The fall in the Australian dollar over the last few years significantly boosted USD returns which was the reverse of the period. This raises the question of the relative volatility of global small-caps relative to global large-caps. As would be expected, global small-caps which tend to be less liquid and more peripheral in investor portfolios (that is, have a higher beta ) are more volatile in both up and down markets. Australian small-caps (the orange line on the chart) have a different volatility pattern, reflecting the boom bust commodity cycle. The chart smooths the data by using the rolling annualised standard deviation over 3 years of monthly returns.

7 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 7 Global Small-Cap & Global Large-Cap rolling annualised Std Dev 3yrs of monthly returns In terms of correlation of returns between the equities asset classes, the correlation between MSCI World Small-Caps ex Aust (AUD) and the ASX Small Companies index has averaged around 0.5 over the last 15 years. More recently, the correlation has dropped sharply due to the demise of the resources (materials) sector as commodity prices have plunged and Chinese economic growth has slowed MSCI World Small-Caps ex Aust (price) AUD & ASX Small Ords Accum (rolling 36mth correlation of monthly returns) MSCI World ex Aus Small-Cap USD STD DEV month Rets 36 month MSCI World ex-aus(usd) STD DEV 1 month Ret 36 month ASX Small Ords Accum STD DEV 1 month Returns over 36 month Another way to adjust for risk is to calculate Sharpe Ratios. Here the track record for global small-caps is more mixed over different time periods. Over a 10 year period (which is long enough to allow currency effects to wash out ), the global small-caps Sharpe Ratio is the best at 0.19 which compares favourably to Australian large-cap equities (at 0.15). Over a 15 year period, Australian large-cap equities (ASX 200) at 0.36 have the best Sharpe ratio. Sharpe ratios 3yr 5yr 10yr 15yr ASX 200 Accumulation ASX Small Ords Accum (Ex 100) MSCI World ex Aus Small-Cap Index (USD, net) MSCI World ex Aust (USD, net) MSCI World ex Aus Small-Cap Index (AUD, net) MSCI World ex Aust (AUD, net) MSCI World Small-Caps ex Aust (Aud,price) 1 mth % & ASX Small Ords (Ex 100) 1 mth%, rolling 36m correlation Comparing the correlation between MSCI World Small-Caps ex Aust (AUD) and the MSCI World Large-Caps index, it can be seen that the correlation has been fairly high in recent years, reflecting the bull-run after the Global Financial Crisis. Prior to 2004, the correlation fell to 0.5 during the tech-boom and tech wreck period.

8 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 8 MSCI World ex Aust Small-Cap & MSCI World ex Aust Large-Cap rolling 36m correlation of monthly 1.0 Sector Performance (10 years to Jan 2016): World Small-Caps minus World Large-Caps Utilities Telecom Services IT Financials Health Care Cons. Stp. Cons. Disc. Industrials Materials Energy MSCI World ex Aust Small-Cap 1 mth % & MSCI World ex Aust,1 mth, rolling 36m correlation Key Sector and Investment Style drivers of Global Small-Cap performance With respect to style bias, in the period to end January 2016, the growth style has outperformed value over the last 1 year, 3 year and 5 year periods respectively. More recently, over the last six months, growth has begun to underperform. Comparing the difference in sector performance over the last decade between MSCI World Small-Caps ex Aust (AUD) and the MSCI World Large-Caps index (see chart), outperforming sectors were utilities, financials and materials. Laggard sectors were energy, consumer discretionary and information technology. MSCI World Small Cap % change end Jan 2016 MSCI World Small-Cap (AUD) MSCI World Small Growth (AUD) MSCI World Small Value (AUD) 1m 3m 6m 1yr Ann. 3yr Ann. 5yr Source: FE Analytics, % per annum, AUD terms, 29/1/16

9 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 9 3. Optimal allocation to the MSCI global small-cap (ex aus) sector Introduction to the optimisation analytical approach. There are many modelling methodologies than can be used to analyse the optimal asset allocation. We have used a conventional mean variance methodology. The analysis was undertaken by Heuristic Investment Systems (HIS) who are specialist asset allocation experts based in Melbourne, Australia. Assumptions Used in the Mean Variance Analysis A systematic economic and statistical framework is used to estimate returns, volatilities and correlations. Return projections for Global Small-Caps are based on a building blocks approach (that is, building up the return expectation based on expectations for GDP (sales) by region, margins, dilution/buybacks, dividends, PE change). This building blocks approach is illustrated in the following chart: The mean variance approach involves projecting returns for the asset classes being compared, usually over the medium term (a 10 year period) and estimating corresponding volatilities (or risk) and taking account of the way in which various asset classes are correlated. Then the global smallcaps theoretical allocation (or weighting) is varied through simulations until the best or optimal weight is identified. Given that the model can allocate excessively to one asset class just based on the quantitative inputs, limits need to be placed on certain asset class weightings to ensure that a sensible diversified portfolio recommendation is generated. Equities sales + margin change - issuance + buybacks = EPS growth + valuation change + div yield + inflation Bonds & Credit yield + roll + change in yield + credit margin + change credit margin + hedge return REITS yield + EPS growth + change in spread We have tested typical balanced portfolios that include Alternatives (hedge funds and private equity). Traditional asset classes included are: Australian equities (large and small-cap), Global equities, Emerging Market equities, listed and direct property, Australian and overseas fixed interest, credit and cash. Long-Term Asset Class Return Assumptions A key feature of these assumptions is that they are relatively low compared to recent historical experience as global economic growth is seen as remaining sub-par and global cash rates and bond yields are at very low levels (around 25% of the global sovereign bond market is trading at negative yields). Clearly, these projections are sensitive to changes in the global economy and investment markets. If account is made for Australian dividend imputation then the optimal weighting may be lower, say at 3%.

10 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 10 Long-Term Return projections Asset Class (next 10 yrs p.a.) Nominal Global Equities LC (DM, unhedged) 6.50 Global Equities SC (DM, unhedged) 7.50 Emerging Market Equities (unhedged) 8.00 Australian Equities LC 7.25 Australian Equities SC 8.00 REITs 6.25 Direct Property 7.00 Domestic Bonds 3.00 Global Bonds 2.75 Credit 4.75 Private Equity 9.50 Hedge Funds 4.75 Cash 3.00 Source: MSCI, IRESS, Cambridge Associates, Eurekahedge, US Fed Source: Heuristic Investment Systems (HIS) 9/2/16 Long-Term Risk and Volatility Assumptions This table shows the historic correlation between the various asset classes using monthly return data over the last 15 years. Since there were several economic cycles and shocks in this period, it is a reasonable input for asset allocation modelling. However, as noted above, changes in the global economy and investment markets mean these measures can be volatile in the short term and trend differently in the longer term. Of note, is that global small-caps are highly correlated with global large-caps (0.88), private equity (0.70) and global emerging market equities (0.70). There is a 0.49 correlation with Australian small-caps. We are using unhedged global equities in this analysis. With regard to volatility (risk), global small-caps are 14.9% which is below Australian small-cap (19.6%) but above global large-cap (12.5%). Correlation Matrix based on monthly returns past 15 years Aus Equities Aus Smalls Hedge Funds Global Bonds Private Equity MSCI EM(unh) MSCI World ex Aus LC net(unh) MSCI World ex Aus SC net (unh) Direct property Aus Bonds Aus Cash US Credit (50% HY/50% IG) Aus Equities 14.4 Aus Smalls Hedge Funds Global Bonds Private Equity MSCI EM(unh) MSCI World ex Aus LC net(unh) MSCI World ex Aus SC net (unh) Volatility Direct property Aus Bonds Aus Cash US Credit (50% HY/50% IG) Source: MSCI, IRESS, Cambridge Associates, Eurekahedge Source: Heuristic Investment Systems (HIS) 9/2/16

11 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 11 Results of the Analysis Based on the above assumptions and modelling work, we estimated a range of efficient portfolios allowing the strategic weightings to global and Australian small-caps to maximise at 5%. The chart shows the combination of optimal portfolios for expected return with the asset class weighting on the left axis. Asset classes are shown in various colours. The chart shows that for virtually all expected return projections, it is warranted to hold a 5% weighting in Global Small-Caps (shown in pink). Australian small-caps (shown in red), start to appear in the model simulation around 6% and grow to the 5% maximum at 7% expected return. If account is made for Australian dividend imputation then the optimal weighting would be lower, say at 3%. Efficient Portfolios (with Alts, with Global & Aus Smalls, max 10% each) 100% 90% 80% 70% weighting 60% 50% 40% 30% 20% 10% 0% 4% 5% 6% 7% expected return Aus Cash Aus Bonds Direct Property MSCI World exaus SC net MSCI World exaus LC net MSCI EM (AUD) Private Equity Global Bonds Hedge Funds Aus Smalls Aus Equities LC Source: Heuristic Investment Systems (HIS) 9/2/16

12 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 12 If the allocation is allowed to rise to 10% for both global and Australian small-caps, then it does not take long for the higher risk of those asset classes to dominate any increase in potential returns. Also, of interest is that the allocation to global small-caps primarily comes from global large-caps and emerging markets which are observed in practice with most investor model portfolios. This relationship is shown in the following bar chart: Change in efficient portfolio: (no smalls to max 10% Global & Aus smalls) 25% 20% 15% 10% 5% Weighting 0% -5% -10% -15% -20% -25% change in return minus change in volatility 0% 0.02% -0.02% -0.1% -0.2% -1.4% Aus Cash MSCI World exaus SC net MSCI EM (AUD) Aus Smalls Aus Equities LC Private Equity Direct Property Hedge Funds MSCI World exaus LC net Aus Bonds Global Bonds Source: Heuristic Investment Systems (HIS) Conclusion recommended asset allocation weight to Global Small-Caps ex Aus Based on the assumptions and analysis above, the recommended strategic asset allocation weight would be up to 5% of a typical balanced portfolio including Alternatives (namely diversified hedge funds and private equity). A significantly larger allocation would tend to add unwanted volatility to the theoretical balanced portfolio.

13 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS Alpha (excess return) factors for small-cap managers For Australian investors, small-cap stocks are commonly viewed as a significant source of alpha and this has been the case. One drawback is that due to the small size of the market, local small-cap managers tend to reach capacity at relatively low levels of funds under management. Given ongoing inflows from Australia s large compulsory superannuation system, this means that global small-cap equities offer an attractive alternative. There are a number of factors that suggest the global small-cap managers are likely to achieve reasonable levels of active returns on a persistent basis and offer relative value for money after adjusting for active manager fees, risk and liquidity constraints. These factors are: Broad Investment Universe and low index concentration As discussed above, stock dispersion is likely to be large given the large number of stocks in the index and fact that their index weightings are not very concentrated. The global developed market small-cap stock universe includes approximately 4,191 stocks, dwarfing the large-cap market, which consists of approximately 1,581 stocks (as of 31st January 2016). Therefore, active managers are able to build unique diversified portfolios with high active share. Average Analyst Stock Coverage is low in small-caps One significant factor that makes the global small-cap universe less efficient than large-cap, is that sell-side research analyst coverage is significantly less. The chart (from AMG Funds) shows that large-caps are covered by sell-side analysts while small-caps only by 5-6 analysts. This means that there is more scope for a manager with a strong internal research capability to find undervalued stocks. As small-cap stocks tend to be more closely linked to domestic economies, there is a case to have these analysts located in the relevant regions. Average Analyst Coverage ACWIxUS SC ACWIxUS Russell2000 Russell1000 Source: Factset, as of 31/7/15 Good alpha potential fast growing universe The small-cap stock universe has a bias to growth stocks and IPOs (initial public offerings) whereas the large-cap universe has a bias to more mature companies. This means that active small-cap managers are more likely to hold ten baggers and participate in fast growing industries.

14 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 14 Active manager performance range With a broad investment universe available, high active share and higher volatility than large-caps, it is no surprise that there is a wide dispersion in active global small-cap manager performance. Over the three year period to 31st December 2015, according to evestment data, gross manager total returns ranged from -4.05% to % with the median at 11.98%. In the longer term, over 10 years, returns ranged from +2.84% to % with the median at 7.42%. Note that the sample size of managers which was 23 for the ten year period and has now grown to 59 as more managers release global small-cap products into the market. Another important point to note is that managers that are in the 25th percentile and above consistently generate alpha (excess returns) well above the median (see table) and have recorded information ratios above This is shown in the following evestment table that divides the active global small-cap manager universe into percentiles around the median. Global Small-Cap Manager Excess % Returns and Information Ratios (USD) Percentiles Excess Rtn 1 yrs Excess Rtn 3 yrs Excess Rtn 5 yrs Excess Rtn 10 yrs Information Ratio - 3 Yrs Information Ratio - 5 Yrs Information Ratio - 10 Yrs High th Percentile th Percentile Median th Percentile th Percentile Low Observations Source: evestment Global Small-Cap Equity, USD terms. Gross of fees. (31/12/15)

15 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 15 Risks As noted in Section 1, global small-cap stocks (ex Aus) have tended to have higher volatility than global large-caps which means that they are riskier. This is taken account of by active manager stock selection and portfolio construction as well as by the appropriate allocation to the sector in a diversified portfolio. More specifically, some of the major risks that active managers have to consider are: Liquidity - This becomes an issue particularly if managers hold stocks at the lower end of the market cap spectrum and their funds under management are growing rapidly. All things being equal, high turnover growth styles can be problematic at times. Unintended sector and macro positions - When constructing portfolios from the bottom-up or stock by stock (usually via regional bolt-ons ), managers need to take account of unintended sector or macro biases, for example to financials or the consumer discretionary sector. For diversified investors, these exposures need to be compared to positioning elsewhere in the portfolio, for example, in global and domestic large-caps, domestic small-caps and emerging market equities. Manager selection plays a crucial role in ensuring that there is consistency and predictability over time. Stock quality relative to large-caps - Small-cap stocks are usually perceived as being lower quality than large-caps but this can be overcome by careful selection and analysis by the active funds manager. Currency - Given the diverse range of developed countries and stock specific approach to portfolio construction, managers tend to have an unhedged exposure to the global small-caps sector. Australian investors can manage their foreign currency exposure as they would do for other parts of their diversified portfolios. Active managers can add alpha on a net of fee basis This brief overview of the alpha potential for global small-cap equity managers suggests that higher quality active managers are likely to generate sufficient riskadjusted excess returns to justify typical base fees. In identifying suitable managers, attention needs to be paid to factors such as liquidity management, sector and macro risk positioning (especially relative to the investors other sector holdings), stock quality and currency management.

16 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 16 Conclusion Analysis suggests that an unhedged Global Small-Cap stocks allocation up to a total strategic asset allocation weighting of up to 5% is likely to improve the return / risk trade-off a typical Australian balanced portfolio that includes Alternatives (hedge funds and private equity). The analysis was a based on a conventional mean variance optimisation technique that involves projecting returns for the asset classes being compared, usually over the medium term (a 10 year period) and estimating corresponding volatilities and taking account of the way in which various asset classes are correlated. Then the global small-caps theoretical allocation is varied through simulations until the best or optimal weight is identified. This analysis is not done mechanically as judgement is required to avoid loss of diversification benefits. The optimisation incorporated consideration of current and historic data over a 15 year period. This period is long enough to incorporate a number of investment and currency cycles including major events namely the tech wreck, Global Financial Crisis and recent China commodities boom. Essentially, projections for medium term asset class returns are relatively subdued as global economic growth is seen as remaining sub-par and global cash rates and bond yields are at very low levels (around one-quarter of the global sovereign bond market is trading at negative yields). Based on detailed analysis of the factors driving company returns at an aggregate level, it is assumed that the GSC ex Aust. (unhedged) sector can generate returns of 7.50% with an annual volatility of 14.9% per annum. Australian largecap equities assumptions are similar (7.25% return, 14.4% volatility) while Australian small-cap assumptions are higher in both respects (8.00% return, 19.6% volatility). Clearly, these projections are sensitive to changes in the global economy and investment markets. If account is made for Australian dividend imputation then the optimal weighting would be lower, say at 3% Global Small-Caps (GSC) can therefore create potential for additional return in a diversified equities allocation given that the Australian small-cap sector is small (only 0.4% of the global equities universe) and is overweight in a narrow range of sectors, particularly materials (resources) and consumer discretionary. Analysis of historic index data (or beta ) shows that the GSC sector has delivered relatively high risk-adjusted returns (as measured by the Sharpe ratio) over the last 10 and 15 years. The case for using active fund managers to invest in global small-cap equities is strong. Firstly, there is a broad opportunity set with opportunities for good stock pickers. This is evident from the observation that for developed countries, a commonly used index is the MSCI World Small-Cap Index ex Aus ( MSCI WSC ) which at AU$6.4 trillion represents about 13% of the total listed global equities market which totals AU$49.3 trillion. For MSCI WSC there are currently 4,191 stocks in the index which indicates the vast number of possible investments available. As the index is not highly concentrated, active fund managers can construct well diversified portfolios with high active share.

17 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 17 Secondly, an analysis of GSC manager returns (using a large USD data set) shows that managers that are in the 25th percentile and above (according to evestment data covering the last 10 years to 31st December 2015) are consistently able generate alpha (excess returns) of around 3% plus which is well above the median and with respectable information ratios at around 0.50 over the longer term. The last three years have been particularly good for active fund managers with the higher performers generating excess returns between 3% and 9% and information ratios well over one. Thirdly, there is a wide dispersion in manager returns over all time periods. This supports the view that managers need to actively manage their risks across a range of dimensions (particularly, liquidity, unintended sector and macro positions, stock quality and currency). Overall, there are sound reasons, supported by comparative market, asset class optimisation and manager return analysis, to maintain a significant strategic weighting (up to 5%) in a well diversified Australian balanced portfolio. As this is a dynamic sector with significant potential alpha and a range of specific risks, there is scope to justify using active fund managers.

18 TOPIC PAPER APRIL 2016 GLOBAL SMALL CAPS 18 About Eaton Vance Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today s most discerning investors. For more information, visit eatonvance.com. About Douglas Funds Consulting Nigel Douglas is Chief Executive Officer (CEO) at Douglas Funds Consulting Pty Ltd (AFSL No ) which is an independent research firm that undertakes customised fund and client specific research projects as well as investment committee and non-executive director roles. Mr Douglas has over 30 years financial markets experience with high level expertise in investment manager research, asset allocation and macroeconomics.

19 This document is for Professional/ Wholesale Investors ONLY. The opinions and views expressed in this document are those of Douglas Funds Consulting and Eaton Vance and should not be construed as investment advice. Past performance is not a guide to future returns. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested. The information contained within this document should not be construed as a recommendation to buy or sell a security. It should be assumed that a security has been or will be profitable. This material is presented and issued by Eaton Vance Management (International) Limited ( EVMI ), which is authorised and regulated by the Financial Conduct Authority in the United Kingdom and is located at 125 Old Broad Street, London, EC2N 1AR, United Kingdom. This presentation is for Wholesale Investors ONLY. In Australia, EVMI is exempt from the requirement to hold an Australian financial services license under the Corporations Act in respect of the provision of financial services to wholesale clients as defined in the Corporations Act 2001 (Cth) and the Australian Securities and Investments Commission s (ASIC) Class Order 2003/1099. As stated above, EVMI is regulated by the Financial Conduct Authority under the laws of the United Kingdom, which differ from Australian laws. EVMI is a wholly owned subsidiary of Eaton Vance Management. Eaton Vance Management ( EVM ) is an investment adviser registered with the United States Securities and Exchange Commission ( SEC ) and is a wholly owned subsidiary of Eaton Vance Corp. ( EVC ). The non-voting common stock of EVC, parent company of EVM, is publicly traded on the NYSE under the symbol EV. For purposes of this presentation, Eaton Vance or the Firm is defined as all three entities operating under the Eaton Vance brand.

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