When it comes to investing, there are certain segments of the market that active management can play a big role in helping to gain index-beating returns. Often these segments feature inefficient assets, avoidance from many institutional players, and a difficulty in valuation. This is where active managers can apply their best efforts to find diamonds among the coal – and one of the best areas is when you think small.
Small-cap stocks have been a preferred stomping ground for active managers. And it turns out this is a great place for them to be as they can add alpha to their investors’ bottom lines.
With the surge in active ETFs, small-cap stocks could even be better. Here, active managers can take advantage of the wins of small-cap stocks’ wins, as well as all the benefits of ETFs. With lower costs and tax advantages, active ETFs could be a powerful tool in this inefficient market.
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
Small Caps & Active
Think about Apple, both as a stock and a company. There are thousands of articles published each day on Apple’s stock about what new products are coming out, the personal life of CEO Tim Cook, etc. There are currently 44 different analysts who cover the stock; not to mention an army of bloggers and independent writers digging into the firm’s finances. Now take a look at optical and laser specialist II-VI. There’s a good chance that you’ve never even heard of the firm.
The general definition for small-cap companies is those with a market cap between $300 million to $2 billion. Often firms in this realm are starting out in their journeys as companies. As such, they can pack a powerful growth component to a portfolio. However, not all small-caps are start-ups – many feature mature businesses, and even steady dividends.
This underscores the power of small-cap stocks and active management.
The market segment is a complex environment, and it takes plenty of time to get right. The problem is, if you’re a $100 billion pension fund, you don’t necessarily have the time to do the necessary research to dig through all the firms. Secondly, because of their smaller market, the amount of money needed to create a position in a huge fund can actually distort share prices. With that, many larger and institutional investors stick to larger firms like Apple.
But for managers willing to do the work and shift through small-caps, the results can be impressive.
According to data from Morningstar, managers in the space typically lead to outperformance. Looking at rolling three-year periods from 2005 to 2019, the average small-cap manager outperformed the Russell 2000 (the main small-cap benchmark) 86.7% of the time. Better still is that these managers managed to have an excess 1.5% return after fee/fund expenses. Better still were managers who focused on investment “styles.” Small-cap growth managers managed to beat their benchmarks 94% of the time, while small-cap value managers did so 91% of the time. Value managers managed to add an additional 2.5% in returns after fees as well.
Mid-cap and large-cap managers? Not so much. They managed to underperform and realize negative average returns.
This outperformance has continued today. Analysts at Jefferies have shown that the average small-cap core fund was ahead of the Russell index by 3.1% in January, with Jefferies’ analyst Steven G. DeSanctis saying “Alpha generation is alive and well in small-caps.”
Thanks to the overall inefficiency of the market segment, active managers can really dig in, do real research, and find the best stocks. There’s plenty of additional benefits they can add.
Active ETFs Make Small-Caps Better
This outperformance is about to get even better for investors. That’s because the ETF structure can enhance active managers’ small-cap wins even further.
For starters, small-cap funds tend to feature high turnover and generate a ton of capital gains for their investors. This is particularly true for funds operating in the small-cap growth segment as managers sell outperforming stocks. But the ETF structure mitigates these gains and the taxes that come with them thanks to the creation-redemption function. ETF managers can pass-through gains/taxes without affecting their shareholders.
Secondly, costs for ETFs are overall cheaper. Because of the extra research and trading costs associated with small-cap stocks, funds in the segment tend to be more expensive versus large-cap stocks. However, this is not so with ETFs, as the lower costs can provide a hurdle for managers to clear.
And finally, front-running risks are lower with ETFs as well. Thanks to the growth of semi-transparent and non-transparent ETFs, managers can keep their secret sauce hidden while they build positions, make investment decisions and create an ideal strategy.
Don’t forget to explore our Dividend Guide where you can access all the relevant content and tools available on Dividend.com based on your unique requirements.
Making the Jump to Small-Cap Active ETFs
Given the benefits of active management in the small-cap space, investors should consider making a portfolio play here. The best part is the growth in active ETFs has continued to add new funds covering the market segment. Already, we’ve seen a plethora of launches covering the space- including the Avantis US Small Cap Value ETF (AVUV), Dimensional Fund Advisors Small-Cap ETF (DFAS) and AlphaMark Actively Managed Small Cap ETF (SMCP) launched over the last few quarters.
And the numbers continue to grow.
As with any investment, investors need to dig into the various funds in the segment and do due diligence. However, given the outperformance and benefits of active small-cap management, investors should consider making the switch to active ETFs in the space.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.