Produced By: Ensombl
In the ever-changing world of finance, one of the perennial questions for advisors is how best to balance the varied interests of their clients with the opportunities and risks posed by different asset classes. Australian small-cap equities represent one such opportunity. They appear appealing because of their growth potential, intriguing sector diversity, and the possibility of uncovering the next market leader before it becomes a household name. Yet in advising clients on small-cap investment, financial professionals face a dual challenge: they must remain mindful of the macroeconomic forces at play and keep a close eye on corporate fundamentals—all the while upholding the highest standards of professionalism and ethics.
In this article, inspired by a conversation among James Whelan (host), Noah Kaplan (Associate Portfolio Manager at Morningstar), and Phillip Hudak (Co-Portfolio Manager for Australian Small Companies at Maple-Brown Abbott), we will explore the rationale behind small-cap investing, the global and domestic factors that influence its success, and the professional and ethical considerations that guide advisors in recommending such investments. While the original podcast conversation ranged across various areas—from the impact of U.S. politics to interest rate cycles—our written piece will delve more deeply into how professional duty and ethical conduct intertwine with the pursuit of returns in this dynamic market segment.
Before turning to market conditions and small-cap dynamics, it is vital to restate the core principle that underpins the financial services industry: the advisor’s duty to act in the best interests of their client. Small-cap equities, by their nature, can be riskier than well-established large-cap stocks. They often have more limited track records, may rely on a small number of product lines, and typically have less predictable revenue streams. Yet small caps can also offer outsized returns and a genuine opportunity to diversify a portfolio in ways that larger companies do not match.
From an ethical standpoint, advisors must clearly communicate the heightened risks, volatility, and liquidity concerns of small-cap investments to their clients. Transparency is key. The ethos of professionalism compels advisors to base their recommendations on in-depth research and to document their rationale for including or excluding certain segments of the small-cap universe. This approach not only helps protect the investor’s interests but also strengthens the advisor-client relationship. When clients trust that their advisor has conducted thorough due diligence, conflicts of interest are minimized, and the confidence in the recommendations made grows.
Additionally, ethical investing in small caps includes a responsibility to consider a company’s governance, sustainability practices, and the broader social or environmental impact of its business model. While not every small-cap company will have the robust corporate responsibility framework that larger entities do, the growing market emphasis on sustainability, governance, and social impact means that conscientious small-cap managers are increasingly transparent about how they conduct business. For advisors, focusing on these areas is not just ethically sound—it can also lead to identifying higher-quality, potentially more resilient investments.
As part of any recommendation or decision-making process, professionals need to evaluate the past performance of small-cap equities—locally and globally. Historically, the idea of a “small-cap premium” has existed, suggesting that smaller companies may deliver higher returns than their larger counterparts over the long run, partly to compensate investors for the higher level of risk.
Globally, small-cap returns can be compared against major benchmarks such as the Russell 2000 in the United States or the MSCI World Small Cap Index. Performance has often been cyclical. At certain times—particularly when monetary policy is tightening—small caps can underperform. When central banks pivot toward more accommodative monetary policy (lowering interest rates, for example), smaller companies can benefit from cheaper access to capital and improving sentiment among investors who become more risk-tolerant.
In the conversation that inspired this article, it was noted that both international and Australian small caps have faced difficult periods in recent years. The tight global monetary conditions of 2022 were especially challenging. Rising interest rates make it tougher for small businesses to roll over debt, and the cost of borrowing can significantly reduce profitability. At the same time, inflation poses a challenge if the company is unable to pass on increased costs to its customers.
Australia’s small-cap market, represented in part by the ASX Small Ordinaries Index, does not always mirror global small-cap trends. There are structural differences in the Australian market. Resources and financials dominate the ASX at the large-cap level (top 100 companies). At the small-cap level, there tends to be a broader spread of sectors. Industrial, technology, healthcare, and niche resource companies often figure more prominently. As a result, Australian small caps can provide exposure to trends or sectors that are not available among large-cap Australian equities.
Moreover, while the general theory is that small caps outperform over time, the Australian small-cap index has not always shown that outperformance in raw index-level data. Nevertheless, in active management circles, the picture is different. Research often demonstrates that Australian small-cap fund managers—especially those with robust research processes—can outperform both the benchmark and their large-cap peers. This phenomenon is attributed to the market’s relative inefficiency and lower analyst coverage of smaller companies, which creates potential for well-researched managers to discover mispriced opportunities.
One of the most striking points in the conversation was how central interest rate cycles are to the performance of Australian small caps. Companies outside the top 100 list have less access to robust, long-term financing options. They cannot raise capital via corporate bonds on the same favorable terms as larger entities, nor do they command the same bargaining power with banks. As a result, small-cap corporations can be vulnerable in periods of rising rates.
When interest rates fall, however, the picture can quickly reverse. The cost of capital becomes cheaper, expansions become more feasible, and investor sentiment tends to shift toward riskier segments of the equity market. Thus, small caps often do well in environments where rates are either stable or declining, leading many to watch the Reserve Bank of Australia (RBA) with keen interest. If the RBA transitions from a tightening cycle to an easing cycle, small-cap valuations may lift.
Ethical Note: Advisors, while staying alert to the macro environment, must resist making sweeping recommendations solely on the premise of anticipated rate changes. Ethical practice calls for carefully matching the client’s specific risk tolerance and time horizon with the inherent volatility of small-cap exposure. Relying too heavily on predictions about rate cuts or hikes can be misleading. Financial professionals must explain that, while cycles can offer tailwinds or headwinds, no one can perfectly predict central bank policy. Ensuring clients understand these uncertainties is a sign of professional integrity.
Investment decisions do not happen in a vacuum. The original conversation raised the hypothetical effect of U.S. politics on global markets. When political changes alter trade policies, especially with China—a major partner for Australian exports—any shift in tariffs or sentiment can have a ripple effect on Australian companies. Mining stocks are particularly sensitive to Chinese demand trends. If trade frictions with the United States drive China to find new trading partners, ironically, Australian resource exports might benefit or suffer, depending on the nature of those partnerships and the commodities in question.
Similarly, any U.S. administration that is perceived as “pro-business” could embolden global equity markets and strengthen the U.S. dollar. In such an environment, gold—often viewed as a hedge—might appreciate, and Australian gold producers in the small-cap space might see disproportionate gains due to their higher operating leverage. This possibility illustrates a hallmark of small-cap investing: disproportionate sensitivity to macro and geopolitical shifts.
Ethical Note: Politics can be polarizing, and mixing it into investment advice must be approached with discretion. A professional’s role is not to speculate on headlines but to analyze how tangible policy decisions or trade agreements might influence sectors and companies. This analysis should then be communicated objectively to clients. Advisors must avoid letting personal political biases influence their guidance, as objectivity is a core tenet of ethical conduct in finance.
One of the strongest arguments in favor of Australian small caps is the range of sectors they encompass compared to the relatively concentrated large-cap index. Below are a few key areas frequently highlighted:
Ethical Note: Even with these enticing narratives, a comprehensive analysis of each company’s balance sheet, business model, and sustainability practices is non-negotiable. Ethical advising requires that any recommendation be supported by due diligence. If a company is reliant on a single product or lacks a clear plan to manage debt, an advisor has a duty to present these red flags to the client.
Passive investment—buying an index that tracks a particular market segment—has grown in popularity, largely because of its low fees and simplicity. In the large-cap space, where information is more widely available and markets are generally more efficient, passive investing can be cost-effective. However, for Australian small caps, active management often has an edge. Why?
That said, not all active managers are created equal. Advisors and their clients should vet the manager’s track record, investment philosophy, risk controls, and ethical standards. A manager’s ability to engage with small-cap company management, conduct site visits, or perform deep fundamental research can significantly enhance the potential for outperformance—while mitigating the risk of getting caught in “story stocks” that fail to deliver on their promises.
Ethical Note: When recommending an active small-cap fund, advisors must disclose the additional fee structures that often accompany active management. Transparency around fees is crucial to maintaining trust. Clients should understand both the rationale for choosing active management and the likelihood that higher fees will be offset by the potential for higher returns or better risk management.
Small-cap stocks are more volatile than their large-cap counterparts. They may react more sharply to economic news, changes in interest rates, or sector-specific disruptions. A major concern historically has been “zombie companies,” businesses that are barely able to service their debt obligations and are reliant on cheap credit to survive. When interest rates rise or credit conditions tighten, these businesses can quickly become insolvent.
Fortunately, market participants have noted a general improvement in the quality of the Australian small-cap universe. The proportion of small-cap firms turning a profit has risen over the past decade, thanks to a wave of capital raisings during the COVID-19 period and the subsequent recovery. Many small-cap companies now have more robust balance sheets and better cash-flow stability, reducing the likelihood of defaults, even in higher rate environments. However, due diligence is still essential.
Ethical Note: Advisors must practice professional skepticism. Even if the small-cap universe appears “healthier” in aggregate, it is not monolithic. Some companies may have pivoted to profitability, but others may still be reliant on external funding rounds. Guiding clients responsibly means digging deeper into the corporate fundamentals of each investment or, at the very least, selecting a fund manager who does so diligently.
How much should a client allocate to small caps? The answer invariably depends on the investor’s financial goals, risk tolerance, investment horizon, and overall portfolio structure. Observers note that placing 20–30% of the Australian equity allocation into small caps (within a broader equity portfolio) may be appropriate for some growth-oriented investors. On the other hand, for more conservative individuals or those nearing retirement, an overweight to small caps might be too volatile.
A few guiding principles can keep allocations ethically and professionally aligned:
The future of Australian small caps will be shaped by several forces: global macro trends, domestic rate policies, geopolitics, and sector-specific demand changes. An advisor who embraces robust professional and ethical standards will remain vigilant through every twist of the market. Proper conduct involves:
Small-cap investing in Australia offers a wealth of potential. From niche resources to cutting-edge technology, from under-the-radar consumer names to specialized healthcare providers, small caps can diversify and enhance returns in an equity portfolio. Yet, as with any higher-volatility investment, the pathway to success is lined with potential pitfalls.
For financial advisors, fulfilling their professional obligations means conducting thorough research, understanding the macro environment, and aligning recommendations with client-specific profiles. From an ethical perspective, it also entails full disclosure of the risks, costs, and vulnerabilities inherent in the small-cap space. Advisors who cloak themselves in the virtues of transparency, diligence, and accountability will be best placed to guide their clients toward prudent and potentially rewarding outcomes.
While the global economic outlook may be in flux—shaped by shifting interest rate cycles and uncertain political landscapes—investing in small caps can still align with client best interest when done correctly. Indeed, as the markets turn from tight monetary conditions to more accommodative stances, and as domestic macro policies eventually pivot, the Australian small-cap sector may find renewed momentum.
Yet the ultimate message for professional advisors is timeless: ethics and expertise go hand in hand. By marrying careful analysis with honest dialogue, advisors can help clients harness the growth potential of small caps while safeguarding them from unwarranted risk. When done under the guiding light of professionalism and ethical responsibility, small-cap investing can be more than just a niche play—it can form a vital part of a well-constructed portfolio, empowering clients to reach their long-term objectives in a conscientious and sustainable manner.
Accreditation Points Allocation:
0.10 Technical Competence
0.10 Client Care and Practice
0.10 Regulatory Compliance and Consumer Protection
0.10 Professionalism and Ethics
0.40 Total CPD Points