Global equities have been performing exceptionally well this year, continuing the trend of robust returns seen in 2023. However, this surge is primarily driven by large-cap stocks. Smaller companies have not fared as well, and this disparity has persisted since 2021. But recent inflows highlight a renewed investor interest in this category.
Mid- and small-cap funds are also lagging behind their benchmarks. Nevertheless, investor confidence remains strong, with new funds continually flowing into these segments year after year.
Through May, the Morningstar Global TME Index recorded a return of nearly 11 percent, following an 18 percent gain in 2023. This impressive performance can be attributed largely to a select few stocks, notably the major US technology companies, known as the Magnificent Seven, and prominent pharmaceutical firms like Eli Lilly and Novo Nordisk.
Stark reality
In contrast, smaller companies have yet to see significant improvement. The Morningstar Global Small-Mid Cap TME Index achieved a modest return of just over six percent this year, significantly trailing the large-cap index. This underperformance is part of a trend that has been evident since early 2021. Over the past three years, mid- and small-cap stocks have underperformed large-caps by an average of 4.5 percentage points annually. For the smallest companies, represented by the Morningstar Global Small Cap TME Index, the gap widens to an average annual underperformance of 6 percentage points.
Investors in global mid- and small-cap funds face an even starker reality. Over the past three years, the average annual return for funds in the Morningstar Global Small/Mid-Cap Equity category was a mere 2 percent, falling nearly 3 percentage points behind the Morningstar Global Small-Mid Cap TME Index. This trend of underperformance extends over longer periods, such as 10 and 15 years.
Inflows for global small/mid-cap equities
Despite these challenges, interest in mid- and small-cap funds is on the rise. In April, the Morningstar category of global small/mid-cap equities was among the top ten categories for inflows within Morningstar’s database of 347 categories. That month alone saw 2 billion euros in new investments into global small-cap funds, following an inflow of 1 billion euros the previous month.
These recent inflows highlight a renewed investor interest in this category. However, investors have consistently shown faith in these funds, as evidenced by the fact that there has not been a single year in the past 16 years where the category experienced an outflow of assets. Consequently, the total assets under management in this category have quintupled since the end of 2014, reaching nearly 60 billion euros by the end of May 2024.
Over the past decade, the importance of passive investment products has grown significantly. In 2014, index funds and ETFs held a market share of 3.5 percent in this category. Today, they account for 45 percent of assets under management. This shift is notable given the perception that small-caps, being a less liquid market, should benefit from active management. Yet, the persistent underperformance of active managers may have driven investors towards index-only funds.
Strong management and sound investment processes
Prominent strategies assessed for this edition of Morningstar’s Fund Radar either have strong management teams and sound investment processes, as assessed by fund analysts, or are rated based on an algorithm applying the same evaluation framework.
One such fund, MFS Meridian Global New Discovery, has earned a People and Process Pillar rating of Above Average from Morningstar’s analysts, resulting in a Silver Medalist Rating for its no-distribution-fee share class. The fund is managed by a team of four, all promoted from equity analyst roles, with Peter Fruzzetti leading since its inception. The team targets small and mid-sized companies with potential for above-average earnings growth, supported by MFS’s extensive equity research.
The fund favours companies with leading market positions, clear pricing power, strong corporate governance, and positive free cash flow outlooks. It typically limits initial positions to companies with market capitalisations around 15 billion dollars, exiting when valuations reach 30 billion dollars. The portfolio, generally comprising around 100 stocks, leans towards a growth style, with sector weightings reflecting these preferences.
Despite the challenges facing mid- and small-cap funds, investor commitment remains robust, driven by a belief in the long-term potential of these market segments.
Ronald van Genderen is senior manager research analyst at Morningstar. Morningstar analyses and evaluates investment funds based on quantitative and qualitative research. Morningstar is one of Investment Officer’s knowledge partners. This article originally appeared in Dutch on InvestmentOfficer.nl.