Following a year of underperformance for most asset classes in 2022, the consensus seems to be that for 2023 investors should brace themselves for recession.
While the US may avoid a significant slowdown, the outlook in Europe is more pessimistic as Western central banks are more likely to overshoot in their tightening, increasing the risk of recession and keeping market volatility high.
Oreana Financial Services is more positive, believing a recession could be avoided in 2023, but the macro environment could nonetheless prove to be challenging for investors as policy rates move higher in the near term.
“Recession does tend to hit small caps first and fastest, although the recovery tends to be a case of first in, first out,” said Isaac Poole, chief investment officer at Oreana Financial Services.
“Investors in small stocks this year will need to hold their nerve against that recessionary consensus backdrop.”
Against this background, FSA asked Poole to select two small cap funds for comparison. He chose: the BlackRock GF Systematic Sustainable Global SmallCap Fund and the Schroder ISF US Smaller Companies Impact Fund.
| BlackRock | Schroders | |
| Size | $240.2m | $272.3m |
| Inception | 1994 | 2000 |
| Managers | Kevin Franklin, Raffaele Savi | Robert Kaynor, Joanna Wald |
| Three-year cumulative return | 3.66% | 1.23% |
| Three-year annualised return | 3.82% | 1.35% |
| Three-year annualised alpha | 2.44 | -1.64 |
| Three-year annualised volatility | 26.04% | 27.16% |
| Three-year information ratio | 0.20 | -0.23 |
| Morningstar star rating | *** | *** |
| Morningstar analyst rating | Neutral | Neutral |
| FE Crown fund rating | ** | *** |
| OCF (retail share class) | 1.87% | 1.84% |
Investment approach
Both funds are small cap funds, but the Schroders fund has a US focus, while the BlackRock fund is a global fund with a US bias.
In August 2022, the Schroders fund changed its process to focus on impact investing and to align with Article 9 requirements.
This has led to a contraction in portfolio stocks to about 40 to 50 names from around 100 previously.
The Schroders fund has also avoided some sectors due to its impact focus, such as energy (1.6%) compared with the BlackRock fund (5.46%). It has also avoided sectors such as alcohol, tobacco, gambling, adult entertainment, weapons, coal, oil and gas by negative screening and increased its weighting in companies with higher female board representation.
Ultimately, the fund invests in companies that have a positive impact on society, but Poole expressed worries that this will increase tracking error.
The fund has a market cap target between $250m and $15bn, and currently there is a clear small growth bias, he also noted.
Poole also pointed out that there is a clear focus on companies with durable business models, strong cash flows and reliable earnings streams.
“The Schroders focus on impact investing on the face of it seems a material shift, but the overlap of holdings with the previous mandate is quite high,” he said.
Morningstar analysts have pinpointed that stocks in the Schroders portfolio are divided into three buckets, depending on impact sources.
Around 20% to 30% of the fund is invested in highly innovative companies whose business model solves a direct need within the SDGs, while 50% to 70% of the portfolio will be in firms that are already generating revenues that have an impact, but do not articulate or highlight that impact.
The remaining portion are invested in firms that require a business model transition in order to survive.
The BlackRock fund adopts a purely quant process that includes machine learning alpha models and signals.
“This makes the process quite unique and one that is relatively new in the global small- cap space,” said Poole.
“This process was developed since 1996 with a clear US bias so the application to a global mandate is still quite new.”
He believes BlackRock still has to prove the applicability of its established process to a wider range of geographies.
The fund’s quant process keeps sector, industry and country weights largely in line with the MSCI ACWI Small Cap index to manage relative performance risk.
Although this reduces style bias and does leave a number of smaller holdings, he believes it can also increase cost and turnover of stock allocation.
Morningstar analysts are clearly not a fan of BlackRock’s machine learning process by awarding it a below average rating for its investment process.
“It just feels too experimental: this is a still-evolving process, while important elements of the strategy rely on technology that is relatively untested in global small caps,” said the US investment research firm.
“Moreover, constant tinkering with the alpha models creates unpredictability about the strategy’s future behaviour, while high trading costs in the small cap arena constrains alpha, given high turnover.”
“The comparison is interesting because both funds have experienced a change in process recently – Schroders as recently as 2022. Both strategies are establishing their bona fides,” said Poole.
Fund characteristics
Sector allocation:
| BlackRock | Schroders | ||
| Industrials | 16.93% | Information Technology | 21.2% |
| Information Technology | 13.31% | Health Care | 20.1% |
| Consumer Discretionary | 12.86% | Industrials | 13.7% |
| Financials | 12.18% | Materials | 13.3% |
| Health Care | 11.83% | Financials | 11.9% |
| Real Estate | 8.36% | Liquid Assets | 6.2% |
| Materials | 6.86% | Consumer Staples | 5.1% |
| Energy | 5.46% | Utilities | 3.4% |
| Consumer Staples | 3.81% | Consumer Discretionary | 3.3% |
| Utilities | 3.39% | Energy | 1.6% |
| Communication | 2.86% | ||
| Other | 2.14% |
Country allocation:
| BlackRock | Schroders | ||
| United States | 52.05% | United States | 84.8% |
| Japan | 9.71% | Liquid Assets | 6.2% |
| Canada | 4.34% | Japan | 3.8% |
| Australia | 3.81% | India | 2.5% |
| Taiwan | 3.49% | Puerto Rico | 2.0% |
| United Kingdom | 3.21% | Israel | 0.5% |
| India | 2.35% | Australia | 0.2 |
| Germany | 2.16% | ||
| Cash and or Derivatives | 2.14% | ||
| Italy | 1.75% |
Top 5 holdings:
| BlackRock | weighting | Schroders | weighting |
| Essent Group | 1.04% | First Solar | 3.9% |
| Andritz AG | 0.98% | Allegro MicroSystems | 3.8% |
| Boyd Gaming Corp | 0.93% | Balchem Corp | 3.6% |
| Pacwest Bancorp | 0.93% | Amalgamated Financial Corp | 3.6% |
| Eagle Materials | 0.88% | SJW Group | 3.4% |
Source: FE Fundinfo. Three-year cumulative returns in US dollars.
Performance
Both funds have fared similar to global market trends throughout a three-year period, according to FE fundinfo.
Since January 2020, the BlackRock fund has generated a cumulative return of 12.04% compared with its sector average of 6.84%.
Meanwhile, the Schroders fund posted a cumulative return of 4.33% against its sector average of 11.83% over the same three-year period.
It is indisputable that the small-cap equities sector and both funds have faced a challenging year in 2022.
For the BlackRock fund, it has temporarily underperformed its sector average when the global markets regained momentum after March 2020, but the tables were turned when the global economy began its downfall later that year.
“In 2022, against a backdrop of heavy losses in the global small-cap market, the fund outperformed but still delivered losses. As could be expected for a small cap fund, risk is relatively high but this does perform relatively well compared with peers,” said Poole.
Poole also believes the recent change in the Schroders fund’s investment process makes it difficult to comment too much on performance, particularly longer-term performance that is so important to asset allocators.
“Performance under the previous mandate was typically strong, reflecting the underlying processes,” he said.
“While the new process retains similar names in the strategy, the weights are different, making it a difficult task to gauge how this will perform through time.”
When navigating through 2022, Poole noted the BlackRock fund relied on outside the US market to gain traction while the Schroders fund made changes to its investment process.
“The outlook for performance may be somewhat reliant on the alpha to be generated from impact factors. In the near term, the recessionary consensus outlook is a significant hurdle for the asset class that will provide both funds ample opportunity to show how their process can be applied consistently in difficult times,” Poole added.
Discrete calendar year performance
| Fund/Sector | YTD* | 2022 | 2021 | 2020 | 2019 | 2018 |
| BlackRock | 0.12% | -16.02% | 17.94 | 12.46 | 27.61 | -17.40 |
| Schroders | 1.03 | -20.83 | 14.25 | 17.17 | 24.01 | -11.83 |
Manager review
The BlackRock fund is managed by Raffaele Savi and Kevin Franklin, who took the helm in April 2017, alongside BlackRock’s scientific active equity group.
The two managers are supported by about 85 research and quant analysts across the globe.
Poole believes both Savi and Franklin have demonstrated long-term experience in managing US small-cap and global large-cap stocks and have started to show they are capable with global small caps too.
On the other hand, Morningstar analysts are more cautious as their expertise in long-only global small caps is still being refined, granting them an average rating for people.
“While the lead managers have ample personal investment alongside shareholders in the US-sold vehicles (investing solely in US small caps), there is no direct alignment to this global strategy given US laws impeding them from investing in the Luxembourg-domiciled vehicle,” Morningstar noted in its analyst report.
Similarly, the Schroders fund was also given an average people rating by Morningstar due to the lack of track record from lead manager Joanna Wald.
Wald took up the reins just months ago and is backed by Robert Kaynor as co-manager.
The duo have worked together for 12 years and Wald has 21 years of industry experience, of which almost 10 years has been covering US small caps.
They are supported by five sector analysts, a quant analyst and an ESG analyst, who each cover around 60 to 80 names.
“A crucial difference is the impact focus of the Schroder funds – the inclusion of an ESG analyst is critical in this space but Joanna’s impact credentials will be important for the success of the strategy,” noted Poole
Conclusion
Morningstar has awarded both the BlackRock and the Schroders products three stars based on historical returns and a forward-looking analyst rating of neutral.
FE fundinfo, which bases its assessment on a fund’s three-year history of delivering alpha, minimising relative volatility and producing consistent returns, awards the BlackRock fund only two crowns, but three crowns to the Schroders fund.
Poole believes both funds are vulnerable in case of a recession as they have undergone shifts in strategy recently.
The BlackRock strategy provides exposure to global small cap, with a bias currently to Asia. While the underlying quant processes appear to be working for now in Asia, that is yet to be tested through a true global recession, he said.
In contrast, Schroders’ impact focus will appeal to many investors given the team’s ability to identify good companies that are yet to re-rate and impact and sustainability being a potential driver of alpha over the medium term.
“But over the course of 2023, we think Asia will prove to be a driver of growth and China in particular may help the global economy dodge a US-led recession, as China exits its zero-Covid policy and benefits from domestic led consumption as it reopens,” he concluded.
“Nonetheless, the asset class itself is likely to command only a small allocation within a diversified portfolio.”
