One of the most often heard claims from active managers is that, while it has become more and more difficult to outperform (to generate risk-adjusted alpha) in large-cap stocks, the market for small-cap stocks remains much less efficient.
The Less Efficient Small-Cap Market
This is the underlying theme of the paper by Elena Ranguelova, Jonathan Feeney and Yi Lu, Under the Radar: Structural Alpha in the Small-Cap Equity Mark, which appeared in the December 2015 issue of the Journal of Investment Strategies.
The authors present seven arguments for why there’s structural alpha to be had in small-cap stocks.
1. The number of analysts covering small-cap equities is significantly smaller than the number of analysts covering large-cap equities. This provides greater opportunity to uncover valuable information.
2. Publication frequency by analysts is significantly lower for small-cap stocks than it is for large-cap stocks. These less-frequent updates create “more uncertainty around earnings estimates and pricing for these companies and, hence, more opportunities for talented stock-pickers to generate alpha.”
3. The dispersion of analyst forecasts is higher for small caps. Higher dispersion creates more uncertainty, and so provides greater opportunity.
4. The largest hedge funds gravitate to large-cap stocks. Thus, there is less information competition in small-cap stocks.
5. The majority of event activity (mergers and acquisitions) occurs in small- and mid-caps, resulting in greater opportunity. The authors write: “Elevated levels of corporate activity tend to drive misunderstanding and mispricing in public markets (e.g., companies undergoing corporate change may engender complex situations), and when combined with the generally reduced informational flow for small caps, may lead to opportunities to extract an analytical advantage. Furthermore, the higher incidence of catalysts in this space (evidenced by the high transaction count) can allow this potential analytical edge to be exploited to a greater degree.”
6. It pays more to get it right in small caps. The authors also cited a study by RBC Capital Markets, “The Value of Perfect Foresight,” that measured the return of perfect foresight on firm earnings, revenue or margins for two sets of companies. Using the S&P 600 as a proxy for the small-cap universe and the S&P 500 for the large-cap universe, both groups were broken into quintiles based on earnings revisions during the month. At the start of each month, the strategy is long the top quintile and short the bottom quintile in each respective universe. If an investor had the luxury of applying this strategy on earnings revisions for small caps, he or she would have earned a 64.6 percent excess return compared to a 34.7 percent excess return by following the same methodology for large caps. Ranguelova, Feeney and Lu state: “Part of this difference can be attributed to the higher volatility of small-cap equities; however, the results strongly indicate how much less efficient the small-cap equity market appears to be.”
7. Idiosyncratic factors matter more for small caps. The authors write: “Stock-specific influences drive approximately 80% of the small-cap opportunity set as opposed to approximately 60% for large caps.” This creates an increased opportunity set for small caps.
In the end, Ranguelova, Feeney, and Lu concluded: “Small-cap equities remain a more fertile ground for differentiated stock picking due a number of structural inefficiencies.”
The authors make a case that many would find compelling. But there’s a simple way to determine if their thesis is correct. Morningstar provides percentile rankings for mutual funds. To test the assertion that the small-cap universe is more fertile ground, we can check the rankings on offerings from two leading providers of passively managed funds: Vanguard index funds and the structured asset class portfolios of Dimensional Fund Advisors (DFA). The lowest-cost versions of their funds are used in the table below when they are available for the full period. (And in the interest of full disclosure, my firm, Buckingham, recommends DFA funds in constructing client portfolios.)
|Large Caps||Morningstar Percentile Ranking*|
|Vanguard 500 Index (VFIAX)||20|
|DFA U.S. Large (DFUSX)||19|
|Vanguard Value Index (VVIAX)||29|
|DFA U.S. Large Value III (DFUVX)||22|
|Vanguard Developed Markets Index (VTMGX)||33|
|Vanguard Emerging Markets Index (VEIEX)||52|
|DFA International Large (DFLAX)||37|
|DFA International Value III (DFVIX)||27|
|*for 10-year period ending Jan 5. 2016|
|Small Caps||Morningstar Percentile Ranking*|
|Vanguard Small Cap Index (VSMAX)||11|
|DFA U.S. Small (DFSTX)||15|
|DFA U.S. Micro Cap (DFSCX)||37|
|Vanguard Small Cap Value Index (VISVX)||20|
|DFA U.S. Small Value (DFSVX)||46|
|DFA International Small (DFISX)||27|
|DFA International Small Value (DISVX)||10|
|DFA Emerging Markets Small (DEMSX)||1|
|*for 10-year period ending Jan. 5, 2016|
Before reviewing the data, it’s important to note that about 7 percent of mutual funds disappear each year. Due to poor performance, these funds are either closed or merged out of existence. Unfortunately, Morningstar’s data contains survivorship bias, as the performance of funds that closed or merged isn’t included. Thus, the actual performance rankings of Vanguard and DFA funds would be considerably better if the survivorship bias were eliminated. Even so, Vanguard and DFA funds outperformed 70 percent of actively managed funds in the large-cap asset classes.
Turning to the small-cap asset classes, where Ranguelova, Feeney and Lu concluded that “small-cap equities remain a more fertile ground for differentiated stock picking due a number of structural inefficiencies,” the evidence tells another tale. Not only did funds from Vanguard and DFA outperform 79 percent of surviving actively managed small-cap mutual funds, but these results are even stronger than the 70 percent of actively managed large-cap funds that they outperformed.
What we can conclude from the evidence is that, just as it is with large caps, active management is a strategy that’s “fraught with opportunity,” perhaps even more so due to the greater trading costs incurred in small stocks. In other words, active management is a loser’s game. While it’s possible to win, the odds of doing so are so poor that it’s not prudent to try.
Investors are becoming increasingly aware of just how much of a loser’s game that active management is (and acting on that knowledge). According to Morningstar, in the first 11 months of 2015, investors added $362 billion to all passively managed stock and bond funds in the U.S. while pulling $140 billion from actively managed funds.
The Bottom Line
Contrary to what most investors think, this trend toward passive investing will make it ever more difficult for active managers to outperform. My co-author, Andrew Berkin, and I explain why in our book, “The Incredible Shrinking Alpha”: “For active managers to win, they must exploit the mistakes of others. It seems likely that those abandoning active management in favor of passive strategies are investors that have had poor experience with active investing. The reason this seems logical is that it doesn’t seem likely that an individual would abandon a winning strategy. The only other logical explanation we can come up with is that an individual simply recognized that they were lucky. That conclusion would be inconsistent with behavioral studies that all show individuals tend to take credit for their success as skill based and attribute failures to bad luck. Thus, it seems logical to conclude that the remaining players are likely to be the ones with the most skill. Therefore, we can conclude that as the ‘less skilled’ investors abandon active strategies, the remaining competition, on average, is likely to get tougher and tougher. As the trend to passive investing marches on there will be fewer and fewer victims to exploit, leaving the remaining active managers to trade against themselves. And that is a game that in aggregate they cannot win.”