Why Small Caps Play a Big Role in Compound KiwiSaver Portfolios
At Compound Wealth, we’re dedicated to helping Kiwis build their retirement savings with portfolios designed to maximise long-term growth. One of the key strategies we employ is allocating a portion of our Compound KiwiSaver portfolios to small-cap equities. Here’s why this approach provides an edge for your retirement savings.
Understanding Small Caps
Small-cap stocks represent smaller companies with market capitalisations typically below $2 billion. These businesses are often in the early stages of growth, offering unique products or services and operating in niche markets. While they may not yet have the scale or recognition of larger firms, small caps have historically demonstrated strong performance over time.
The Case for Small Caps in KiwiSaver Portfolios
1. Higher Potential Returns: Historically, small-cap equities have outperformed large-cap stocks over the long term. This "small-cap premium" arises because smaller companies are often undervalued or overlooked, providing opportunities for outsized returns as they grow and gain market recognition.
Ben Carlson’s analysis in "Is the Small Cap Premium Dead?" provides valuable insights into the historical performance of small-cap stocks. From 1926 to 2021, small-cap stocks delivered an average annual return of 11.99%, surpassing the 10.35% return of large-cap stocks. However, a significant portion of this outperformance occurred between 1975 and 1983, when small caps surged over 1,400%, averaging annual returns of 35.3% compared to large caps' 15.7%. Excluding this exceptional period, the long-term returns of small and large caps are more aligned. For instance, from 1979 through May 2024, the Russell 2000 Index (representing small caps) had an annual return of 10.9%, while the S&P 500 (large caps) returned 12.0%.
These findings suggest that while small-cap stocks have historically offered higher returns, much of this premium was concentrated in specific time frames. Nonetheless, small-cap stocks can still play a crucial role in diversification, as their performance cycles differ from large-cap stocks, potentially enhancing a portfolio's risk-adjusted returns over the long term.
2. Diversification Benefits: Adding small caps to a portfolio can improve diversification. These stocks tend to perform differently from large-cap equities and bonds, smoothing out portfolio volatility over time. This is particularly important for KiwiSaver members in growth-focused portfolios who are willing to embrace higher risk for greater returns.
3. Harnessing Compounding: At Compound Wealth, we understand the power of compounding returns. Small caps, with their higher growth potential, amplify the compounding effect. Over a 20- or 30-year investment horizon, this can make a substantial difference to your KiwiSaver balance at retirement.
Managing the Risks
While small-cap equities offer significant upside, they also come with increased volatility and risk. To address this, we take a disciplined approach:
· Diversification: We include a broad mix of small caps across sectors and geographies to mitigate company-specific risks.
· Quality Focus: We prioritise small caps with strong fundamentals, sustainable business models, and sound management.
· Long-Term View: We encourage investors to stay the course, knowing that short-term fluctuations are part of the journey to long-term gains.
Real-World Examples of Small-Cap Companies
To illustrate the diversity and potential of small-cap stocks, here are some examples across various sectors:
· Consumer Goods & Retail:
Caleres, Inc. (CAL): A footwear retailer and manufacturer that owns brands like Famous Footwear and Dr. Scholl’s.
· Industrials:
Herc Holdings Inc. (HRI): An equipment rental company serving industries like construction and industrial projects.
· Financials:
Essent Group Ltd. (ESNT): A private mortgage insurance provider in the U.S. housing market.
· Healthcare:
Lantheus Holdings, Inc. (LNTH): A provider of diagnostic medical imaging agents, particularly in nuclear medicine.
· Technology:
Cohu, Inc. (COHU): A provider of test handling and inspection equipment for the semiconductor industry.
These companies showcase the breadth of opportunities in the small-cap space, spanning industries from healthcare to technology, energy to financials.
How We Gain Small-Cap Exposure
We partner with three exceptional investment managers—Kernel Wealth, Dimensional Fund Advisors, and Evidential Funds—to provide targeted small-cap exposure in our KiwiSaver portfolios. Here’s why these managers are leaders in their field:
· Kernel Wealth: A New Zealand-based investment manager, Kernel Wealth specialises in low-cost index funds tailored to Kiwi investors. Their innovative approach focuses on delivering robust, scalable solutions that align with the needs of long-term investors.
· Dimensional Fund Advisors: With over four decades of experience, Dimensional is a pioneer in applying academic research to practical investing. They’re renowned for their evidence-based strategies, particularly in small-cap and value investing, leveraging insights from Nobel laureates to drive consistent performance.
· Evidential Funds: Built on the principle of transparency and data-driven decision-making, Evidential Funds integrates cutting-edge research to identify high-potential small-cap opportunities. Their disciplined focus ensures that portfolios capture the benefits of small-cap investing without unnecessary risks.
By combining the expertise of these managers, we ensure our portfolios are positioned to harness the growth potential of small caps while maintaining rigorous oversight and efficiency.
The Big Picture
Allocating to small caps isn’t about chasing trends or taking unnecessary risks. It’s a deliberate strategy to tap into a reliable source of long-term alpha. By blending small caps with other asset classes in our KiwiSaver portfolios, we position you for a more prosperous retirement.
At Compound Wealth, we believe in giving everyday Kiwis access to smart investment strategies that were once only available to the wealthy. Our small-cap allocation is just one example of how we help your savings work harder for you.
Ready to make your KiwiSaver work smarter? Let’s chat and craft a portfolio that fits your goals. Contact us today or complete our KiwiSaver Quiz to get started! If you’re interested in learning more about our Compound Portfolio’s take a look at our portfolio page here.
Compound Wealth are a KiwiSaver, Retirement and Private Wealth Financial Advice Firm based in Mount Maunganui, Bay of Plenty with clients all over New Zealand.
