Small and Mid-Caps: Why Now, Why NZ and Why Index Funds

New Zealand small and mid-cap equities are back on the radar. Valuations outside the NZX 50 remain compelling, and the case for allocating more capital to smaller listed companies is stronger than it’s been in years.

At Kernel, we’ve been focused on this part of the market from day one. Six years ago, we launched the Kernel NZ Small & Mid-Cap Opportunities Fund – the first dedicated index fund providing diversified exposure to New Zealand small and mid-cap companies. Our goal was simple: improve access, support better liquidity, and make it easier for investors and advisers to participate in this important segment of the market.

For many advisers, though, small caps still feel hard to access. So, what’s held back adoption, and how can index funds help?

Liquidity gives rise to liquidity — and the reverse is also true: Without sustained investor interest, smaller companies tend to have lower daily turnover. Fewer buyers mean wider spreads, lower valuation multiples, and difficulty exiting positions without moving the price - a real constraint for larger portfolios.

A shallow market deters new listings: Lower liquidity and limited investor appetite create a feedback loop. We hear from private businesses that they’re hesitant to list into a relatively shallow pool of capital. That means fewer IPOs, fewer growth stories on market, and ultimately a narrower opportunity set for local investors.

Higher volatility and business risk: With less diversified revenue streams, small and mid-cap companies can be more sensitive to economic cycles and sector-specific shocks.

Less broker coverage and research support: Broker consolidation and the DIMs regime have reduced analyst coverage, research reports, earnings previews, and valuation comparisons. This makes it harder for advisers to back smaller names with conviction.

Ongoing M&A has thinned out the small-cap universe: In recent years, active M&A has removed several small caps from the market. While takeovers can unlock value through premiums, they can also hollow out market breadth when public valuations fail to keep pace

Collectively, these forces have been a handbrake on the NZX and by extension, New Zealand especially when comparing across the ditch to the ASX. A vibrant public market needs healthy small and mid-cap participation to fuel innovation, jobs, and long‑term growth.

Earnings growth runway: Smaller companies can grow faster off a lower base, especially when they’re reinvesting into a specialised market, expanding their customer base beyond New Zealand or leveraging technology to build efficiency and scale.

Re-rating potential: Liquidity discounts and less attention from big investors can often depress valuations. As sentiment and analyst coverage improve, re-ratings can drive outsized total returns even before earnings have had a chance to grow.

M&A potential: Small caps are frequent targets when strategic buyers seek growth and/or capability and are prepared to pay a premium.

Inefficient pricing: With fewer analysts and less institutional ownership, mis-pricings persist longer, creating an edge for patient, research-led investors.

Diversification benefits: Small-cap performance is typically less correlated with the mega names that dominate the NZX50, improving portfolio diversification and resilience.

Over the past 18–24 months, there has been rising interest from Australian institutions, along with a few big names in New Zealand’s such as ACC, which is a helpful signal. Over a sensible investment horizon, there’s clear valuation arbitrage available with small/mid-caps, especially under $500m, and even more so below $200m market cap. That’s where ambition, reinvestment, and operating leverage can compound.

While the opportunity is attractive, the practical challenges of direct small-cap investing are real:

• Limited research coverage

• Patchy liquidity

• Higher single-stock risk

• Operational complexity for advice businesses

This is where a diversified, rules-based index approach can add real value for advisers.

The Kernel NZ Small & Mid-Cap Opportunities Fund is designed to be one of the tools in your kit:

It provides:

• Broad exposure across a list of eligible companies, reducing single‑stock risk

• Systematic rebalancing that keeps the portfolio aligned to the segment

• Liquidity and operational simplicity for advisers and investors

• A core allocation to the segment that can be used alongside higher conviction active positions where strong research or client-specific preferences exist.

With larger institutions committing more capital into small and mid-caps from both local and offshore institutions we can help close the valuation gap, improve liquidity, and deepen our market. That’s good for investors, and it’s good for New Zealand.