Good things come in small packages

Look out for more Australian small-cap funds hitting the market, particularly from boutique fund managers. There is considerable value to be had by identifying and investing in promising small-cap funds at an early stage, says Lonsec's general manager research, Grant Kennaway.

A key driver of increased activity in the small-cap fund market is the fund size restrictions placed on managers operating in this area. New funds with quality investment teams have strong upside potential while they remain relatively small.

Kennaway's comments come on the heels of the completion of Lonsec's 2005 Australian Small Company Fund Sector Review. It covers 23 fund managers, including ratings on eight fund managers not previously rated for small caps: Advance Asset Management, Ausbil Dexia, Colonial First State — Core, Hyperion Asset Management, OPIS Capital, Pengana, Souls Funds Management, and UBS Global Asset Management.

Lonsec considered it important to rate additional small-cap managers to provide greater choice for advisers in light of recent fund closures and ongoing concerns about funds under management with some existing "open" funds.

Three managers received highly recommended ratings, 10 were recommended and seven were identified as investment grade. However, two managers were placed on fund watch.

Compared with its last review, the 2005 review had Lonsec upgrading one fund — the Credit Suisse Asset Management offering — and downgrading four funds. The ratings were unchanged for the remaining 10 managers previously rated by Lonsec.

Kennaway says: "Lonsec's rating universe covered both well recognised 'brand' managers as well as lesser-known boutique fund managers. Given the size limitations on funds under management in the small-caps sector, Lonsec believes boutique managers will develop a stronger presence in the small-caps sector over time. Furthermore, it is reasonable to expect that new funds, with quality investment teams, have particularly strong upside potential while they remain relatively small in size, suggesting there is considerable value in a proactive research process to identify promising small-cap funds at an early stage."

Boutique managers to rate well as part of the Lonsec review included Eley Griffiths Group, Souls Funds Management and Ausbil Dexia.

While boutique managers can be more dynamic than their larger counterparts, and respond quickly to changing market conditions, investors do need to be aware that they also tend to carry more business risk than larger managers, says Kennaway.

Generally, they are less capitalised, have a shorter history of operation, and the overall business relies on a more specific range of services. However, this risk needs to be balanced against the lower "staff departure" risk of boutique managers, compared with larger fund managers, he says.

Typically, boutique fund managers own their business and, Lonsec observes, they are less likely to depart the business in the near term to pursue other interests.

Lonsec believes size continues to be an issue in the small-caps sector, as larger funds are more likely to confront liquidity issues and are less able to trade to desired portfolio positions in an efficient and cost-effective manner. While Lonsec does not propose an absolute size limit for all small-cap funds, it says the optimum amount would be influenced by investment style, turnover, portfolio bias and portfolio concentration. The overall rating of a given small-caps fund is likely to be impacted by size once it exceeds $650 million under management. This equates to about 1 per cent of the current capitalisation of the Small Ordinaries market.

Leeanne Bland is editor of www.PortfolioConstruction.com.au