The small cap arena continues to be the stronghold of active funds, especially in the UK, where managers have delivered huge outperformance this year. But is there anything issuers and index providers can do to offer ETF investors more competitive strategies in this area?

The small cap story has been no different this year. According to data from Albemarle, some 97.7% of active funds in the Investment Association’s UK Smaller Companies sector outperformed their passive benchmark in Q2, the most across all IA sectors.

Now, although this data only highlights three months of performance, it does provide a snapshot into the struggles of delivering strong performance as a market-cap-weighted ETF as one heads down the size spectrum.

BlackRock is currently the only ETF issuer in Europe brave enough to offer a purely UK small cap ETF through the iShares MSCI UK Small Cap UCITS ETF (CUKS), which currently has $796m assets under management (AUM), a sizeable chunk for an ETF that sits in the realm of active managers. CUKS tracks the MSCI UK Small Cap index, which is a market-cap-weighted index currently offering exposure to 266 stocks.

So why should active managers outperform when investing in small caps? The conventional wisdom is that the market is wholly inefficient compared to the larger cap space. While there will be huge numbers of analysts assessing each move a company makes in the FTSE 100, the same cannot be said for companies in the AIM market, for example.

As Andrew Limberis, investment manager at Omba Advisory & Investments, explained: “There are fewer analysts monitoring small caps, there is less liquidity and there are fewer institutional investors simply due to the size of the small cap market. “This leads to less efficient pricing of securities, which makes a market-cap-weighted index less representative of the true underlying market”.

This is the crucial point. Because stocks are not priced accurately due to the relative lack of analysis taking place, a market-cap-weighted index could struggle to capture the entire market accurately and could lead to overweights or underweights in certain stocks and sectors that active managers can take advantage of.

If it is not a market-cap-weighted approach that will prove successful, then what? The majority of small cap ETFs offering exposure to global, European, US and emerging market equities are market-cap-weighted, however, some issuers have taken a different approach.

WisdomTree, for example, through its range of small cap ETFs, the WisdomTree Europe SmallCap Dividend UCITS ETF (DFE) and the WisdomTree Emerging Markets SmallCap Dividend UCITS ETF (DGSE) fundamentally weight a basket of stocks based on dividends.

The ETFs incorporate quality and momentum factors as well as applying an ESG screen to capture what it determines as “fast-growing, cash-generative” companies.

While an innovative approach, the ETFs have only gathered a combined $83m AUM since launch in 2014 while the firm closed one of the range in August 2020.

Another approach comes from State Street Global Advisors through the SPDR MSCI USA Small Cap Value Weighted UCITS ETF (USSC). Tracking the MSCI USA Small Cap Value Weighted index, USSC looks to capture value stocks by focusing on four metrics: sales, book value, earnings and cash earnings.

This combination of small caps and value has paid off, with USSC among the best performing ETFs this year, returning 25.4% as at 15 September, following the swing back to value in November 2020.

These ETFs show the potential in the space, however, I fear it could be a while yet before issuers are able to fully exploit the potential alpha available in small caps.

This article first appeared in ETF Insider, ETF Stream's new monthly ETF magazine for professional investors in Europe. To access the full issue, click here.

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