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Index-Enhanced Avenue to Swedish Micro Caps

Stockholm (HedgeNordic) – Consistently beating the stock market through stock picking is notoriously difficult. Recognizing this difficulty, Joakim Stenberg, co-founder of the now-closed hedge fund boutique Nordic Cross Asset Management, developed a systematic index-enhanced approach to access an attractive source of long-term returns: Swedish micro-cap stocks.

Despite various definitions of “micro-cap,” Stenberg’s long-only equity portfolio of around 120 companies has an average market capitalization of approximately SEK 3 billion. This is significantly below the fund industry’s current threshold for micro-cap, which includes companies with market values up to approximately SEK 14 billion (0.1 percent of the total market capitalization). 

Joakim Stenberg asserts that the portfolio of his equity fund, Finserve Micro Cap, boasts one of the lowest average market capitalizations by focusing on companies on the main list of the NASDAQ OMX Stockholm Stock Exchange. “No actively managed funds come close to that average market value in the portfolio,” notes Stenberg. However, “the downside of investing in genuine small companies is that the portfolio cannot become particularly large,” he emphasizes. “We estimate that we will hit the ceiling in many companies at SEK 2 billion in managed capital.”

“If you are a portfolio manager covering such a wide range of stocks, which one are you going to pick as the next decade’s winners?”

Joakim Stenberg, Fund Manager of Finserve Micro Cap

Small- and mid-sized enterprises (SMEs) are the lifeblood of every nation’s economy, accounting for most of the economic activity in the European Union. Sweden’s robust ecosystem, depth, and booming IPO market enable investors to finance growth and innovation, and in turn, reap the rewards through stock market returns. “Atlas Copco had a market cap of SEK 5 billion in 2003, compared to today’s cap of SEK 947 billion,” highlights Stenberg. Investing in Sweden’s micro-caps presents the chance to uncover the next “Atlas Copcos” of the region.

“There are a lot of industrial and technology companies, along with other businesses with global expansion ambitions,” says Stenberg. “If you are a portfolio manager covering such a wide range of stocks, which one are you going to pick as the next decade’s winners?” asks Stenberg. Therefore, Stenberg opted to employ a systematic approach to get exposure to Sweden’s entire micro-cap space listed on the main Nasdaq Stockholm Stock Exchange. “It’s essentially an enhanced index approach with a couple of twists,” Stenberg explains.

Enhanced Index Approach with a Couple of Twists

Before deploying the systematic strategy to the space, Joakim Stenberg conducts a thorough screening process from a pool of nearly 200 micro-cap stocks listed on the Nasdaq Stockholm Stock Exchange main market. He eliminates the “A” shares due to their low liquidity, excludes certain stocks associated with controversial and harmful sectors such as the non-renewable energy and gaming sectors, and weeds out highly volatile stocks. “Our systematic model is designed to prioritize low-volatility stocks, as our strategy incorporates a trend-following twist and highly volatile stocks rarely tend to trend over the long term,” elaborates Stenberg. This screening process results in an optimal investable universe of approximately 120 stocks for Finserve Micro Cap.

Relying on research indicating that equal weighting outperforms market-cap-weighted portfolios, Stenberg has chosen to allocate capital evenly across the 120 stocks, ensuring each stock carries equal significance within the portfolio. “In an equal weight portfolio, the smallest company receives the same exposure as the largest company,” notes Stenberg. “Studies have consistently shown that equal-weighted portfolios tend to perform better over time,” he emphasizes. Nonetheless, recognizing that equal-weighted strategies often entail higher stock turnover and subsequent trading costs compared to market-cap-weighted approaches, Stenberg has opted to rebalance the portfolio semi-annually, once in May and again in October to handle historical and known season stock market fluctuations.

“In an equal weight portfolio, the smallest company receives the same exposure as the largest company. Studies have consistently shown that equal-weighted portfolios tend to perform better over time.”

Joakim Stenberg, Fund Manager of Finserve Micro Cap

Any uninvested capital resulting from investor inflows, or dividends received before the bi-annual rebalancing points, is allocated to a group of approximately 25 stocks that are trending upward. “When we receive a subscription well before the rebalancing period, we cannot equally distribute the capital across the whole portfolio, as it would be too expansive each time,” explains Stenberg. “Therefore, we decided to use momentum strategies to allocate to low-volatility trending stocks,” he elaborates. Finserve Micro Fund relies on several indicators or measures of trendiness to reach a consensus on the stocks that will receive the uninvested capital.

“When we receive a subscription well before the rebalancing period, we cannot equally distribute the capital across the whole portfolio. Therefore, we decided to use momentum strategies to allocate to low-volatility trending stocks.”

Joakim Stenberg, Fund Manager of Finserve Micro Cap

The investing process for uninvested capital follows a two-step approach: any net subscriptions during a month are initially invested in an ETF that provides exposure to small-cap stocks until the end of the month. Subsequently, the capital is reallocated to the group of trending stocks. During the rebalancing period in May or October, the entire portfolio is readjusted to equal weights. However, if significant net redemptions compel Stenberg to divest holdings at an unfavorable time, Finserve Micro Cap can rely on a lending facility with a bank. This facility allows the fund to borrow up to ten percent of its assets under management to fulfill redemption requests and offer a high level of investment by holding a small cash position.

Stenberg has also opted to lend out stocks from the portfolio to receive compensation that can cover the costs associated with trading and potentially offset the fund’s fixed management fee. The fee is 1.8 percent for the ‘A’ share class with a minimum investment of SEK 100, and 0.9 percent for the ‘B’ share class with a minimum investment of SEK 1 million. “The compensation that accrues to the fund after fees currently range between 0.5 to 4 percent of the loaned stock value,” says Stenberg. “The interest earned from this lending activity can be seen as a counterbalance to the fixed fee.”

Risk-Return Profile

Micro-cap stocks, particularly within Sweden’s dynamic stock market environment, present investors with the potential for high returns, diversification, and undervalued opportunities. While small stocks are often more volatile than their larger counterparts and are subject to increased downside risk during risk-off periods, Stenberg notes that smaller-sized stocks in Sweden have historically “outperformed larger-cap stocks during bear markets.”

“When Russia started the war in Ukraine, the OMX30 index, large-cap index and the mid-cap index experienced a significant decline, while the small-cap index saw a comparatively modest drop,” recalls Stenberg. This data underscores the resilience of small-cap stocks during bearish market conditions, according to the fund manager. “However, their performance is not as strong during bull markets,” he adds, pointing out that during bullish periods, there tends to be more crowd-driven and flow-driven buying in the ‘larger-sized company’ market segment.

“I believe the potential here is significant, particularly if interest rates come down slightly. In such scenarios, small-cap stocks may be in a better position to finance their businesses and growth.”

Joakim Stenberg, Fund Manager of Finserve Micro Cap

Stenberg elaborates that unlike larger stocks influenced by capital flows, smaller-sized segments of the market are more sensitive to interest rates. “I believe the potential here is significant, particularly if interest rates come down slightly,” concludes Stenberg. “In such scenarios, small-cap stocks may be in a better position to finance their businesses and growth,” he notes. “Given their sensitivity to interest rates, fluctuations in interest rates can significantly change the market dynamics.” 

“The spread between the small-cap index and the mid-cap index has never been greater, which indicates significant potential going forward,” adds Stenberg. Back-testing has shown that by excluding the 20 largest companies from the mid-cap index, the index has performed similarly to the small-cap index over the past two years. “This indicates that companies with a market cap under approximately SEK 8 billion are undervalued, as evidenced by key financial ratios.”

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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