Recent calls for interest rate cuts sparked signs of life for unloved small cap equities, however, this exposure remains one of the as-yet untapped areas in Europe’s active ETF growth story.
Fund selectors have spent much of the last year adding to their US positions while trying to avoid inflating already hefty allocations to large cap equities.
Though most investors have not ventured far enough down the spectrum to access smaller companies, the prospect of lower borrowing costs and attractive valuations may tempt some to revisit the space – especially with tools targeting the most robust names with the strongest earnings potential.
Enter active ETFs
In fact, ETFs actively selecting small cap leaders is what fund selectors are calling for.
Stephan Kemper, chief investment strategist, team advisory desk, at BNP Paribas Wealth Management, told ETF Stream active ETFs “can add real value” in the small cap space.
“Analyst coverage is substantially lower which offers higher chances to generate alpha by identifying untapped or underappreciated investment opportunities,” Kemper said.
“We recently saw noticeable inflows into the classic index Russell 2000 ETFs which seems to have been mainly driven by retail investors. Given the high number of unprofitable companies in the index, this strategy may be appropriate to gain exposure to small caps rather quickly, but it may not the best way to engage into that topic for a longer horizon.”
Dan Caps, investment manager at Evelyn Partners, added active ETFs could offer less blunt instruments for capturing the space versus the various rules-based methodologies on offer.
“The Russell 2000 promotes itself as an unbiased barometer of the true small-cap opportunity set in the US – that is to say it is just concerned with market cap and does not include any profitability screens – and as much as 40% or more of the index is loss making,” he said.
“At the same time, the S&P SmallCap 600 index has profitability and liquidity screens, which may make investors more comfortable, however, it may not be capturing the full-spectrum of the US small-cap space.”
According to data from Vanguard, while there are 380 actively managed products covering small caps globally versus just 40 index-tracking strategies, this expansive active offering has not extended to active ETFs in Europe.
Leaders in the space, JP Morgan Asset Management and Fidelity International, did not disclose plans to enter the space in UCITS format.
Not entirely easy pickings
Given some demand already exists – and asset managers might be able to repurpose some of their existing intellectual property from mutual funds or US-listed ETFs – an onlooker might be forgiven for assuming an active small cap ETF range in Europe would be a low-effort procedure.
However, within open-ended vehicles such as ETFs, the process of managing liquidity and capacity, even within passive small cap ETFs, is no mean feat.
Dale Brooksbank, head of equity indexing group for Europe at Vanguard, said: “We do not try and completely replicate an index in one, we sample and model that through time, to ensure we are delivering the performance investors would expect.
“The ability to source liquidity on a consistent basis requires specialism and regional expertise to navigate those key pockets of liquidity. It also requires monitoring different risk measures, such as examining time to liquidation and headroom issues.”
Caps agreed, saying this process of managing liquidity and capacity means active ETF portfolio managers must consider eligible position sizes alongside analyst expertise on which companies are most merit-worthy.
“While traditional open-ended funds can be shuttered should the fund get too big for the opportunity set, this is not possible with ETFs,” he added.
“In a less-liquid markets, where position size is much more of a concern, this could be an issue for any strategy that is successful enough that fund size becomes an issue.”
Additionally, it also bears considering what flavour of active management would inspire investor enthusiasm, with ‘index-plus’ or systematic active offerings having found most traction within European ETFs to-date.
Kemper suggested the answer to this question will determine who and how small cap active ETFs are used, when they do come to market in Europe.
“The more complicated the ‘add-on’, the lesser an active ETF may be suitable for tactical positioning as the product due diligence may take too long when I want to move quickly.
“Index-plus approaches like the research-enhanced products which exist on certain large cap indices may be the sort of thing with the best chances of commercial success,” he concluded.
