Active Small-Cap Managers Add Value: Myth or Reality? By Larry Swedroe May 30, 2002

Editor's Note: Larry Swedroe's third book, Rational Investing in Irrational Times, recently hit the shelves. For more, see bottom of this article.

One of the more persistent claims from Wall Street is that the inefficiency of information in small-cap stocks allows active managers to exploit market mispricings and outperform passive benchmarks. It is important to note that part of this claim is true - generally, the smaller the market capitalization, the fewer the number of analysts there are performing research on the company. Smaller companies also have less institutional ownership. The lower level of research being conducted might lead to an inefficiency of information. However, inefficiency of information is only a necessary condition for active managers to be successful. It is not, however, a sufficient condition. The sufficient condition is that the information inefficiency has to be large enough that after all expenses of the effort (including the costs of research, trading costs, and fund operating expenses) there is a positive return (alpha) above a passive investment alternative such as an index fund. Unfortunately, as you will see, there not only is no evidence to support the belief that active managers are likely to add value, there is also no logic to the belief either.

When evaluating returns of actively managed funds we must be sure to compare returns to a proper benchmark. Just as you would not compare the returns of an equity manager to the returns of a fixed income manager, you should not compare the returns of small-cap managers to a large-cap index such as the S&P 500. Instead, the returns should be compared to a small-cap benchmark such as the S&P 600 Index, the Russell 2000 Index, or the passive asset class funds run by Dimensional Fund Advisors (which runs both a small-cap and a micro-cap fund). In his famous study, "On Persistence in Mutual Fund Performance," Mark Carhart found that for the period 1962-1993, after adjusting for style (comparing small-cap funds to small-cap benchmarks, value funds to value benchmarks, etc.), the average actively managed fund underperformed its proper benchmark by 1.8 percent per annum. If he had looked at after tax basis the performance would have been even worse. He also found:

• There was no persistence in performance beyond that which would be randomly expected - the past performance of active managers is a very poor predictor of their future performance.
• Expenses reduce returns on a one-for-one basis.
• Turnover reduced pretax returns by almost one percent of the value of the trade. (1)

A study by Russ Wermers, covering the period 1975-1994, found that on a risk-adjusted basis the average actively managed fund underperformed a proper benchmark by 2.2 percent per annum. Once again, this figure is before the negative impact of taxes. (2)

A study by Jim Davis, covering the period 1968-1998, examined the returns of 4,686 funds. Davis sorted the funds into deciles by market capitalization. He found that there was no evidence of any superior performance of active managers. In fact, the alphas were the most negative in the very largest (perhaps because of high efficiency of information) and the very smallest (perhaps because trading costs are greatest) deciles. Davis also found no evidence of abnormal persistence in performance. (3)

It is important to note that the Carhart, Wermers, and Davis studies are all free of the survivorship bias that often appears in studies showing that active managers have outperformed. Funds that perform poorly close either because of redemptions by investors or because they are merged out of existence by their sponsor. Thus their performance data disappears. The mantra of active fund management might be described as: If at first you don't succeed, destroy any evidence that you tried. Various studies have found that survivorship bias magically improves returns by as much as 1.5 percent per annum. In fact, since survivorship bias is even greater for small-cap funds, data with survivorship bias might be inflating returns by even as much as two percent per annum. (4)

There is another bias in performance data that comes from the use of what are known as "incubator funds." Incubator funds are newly created funds, seeded by mutual fund families with their own capital. The funds are not available to the public. Here is one way the game may be played. A fund family creates several small-cap funds, possibly even under the same manager. Each fund might own a different group of small-cap stocks. The fund family incubates the funds, safe from public scrutiny. After a few years they bring public only the fund with the best performance. Magically, the performance of the other funds disappears. Unfortunately, a recent SEC ruling allows fund families to report the pre-public performance of incubator funds. Thus we have the potential for huge distortion of reality.

The historical evidence is very clear that there is no evidence supporting the claim that active managers outperform in informationally inefficient asset classes. The arithmetic of active management also makes it basically impossible for active managers in aggregate to outperform. The reason is simple: All small-cap stocks must be owned by someone. With this understanding it is easy to demonstrate that in aggregate passive small-cap investors must realize greater returns than active small-cap investors.

The Arithmetic of Active Management

There are only two types of investors, passive and active. Passive investors in small-caps earn the gross rate of return of the asset class, less low costs. Because the sum of the parts must equal the whole, active small-cap investors must then also earn the same gross return as do the passive small-cap investors. However, since their costs are higher they must earn lower net returns. The math is so simple that it is amazing that the myth persists.

It is important to note that the math of active investing is not only applicable to small-caps, but also to any asset class. The math also makes it irrelevant as to whether the market is in the bull or bear phase - the math is the same, thus exposing another myth: Active managers can outperform in bear markets.

There will always be some active managers that outperform their appropriate benchmark, even for very long periods of time. This provides hope for believers in active management. Unfortunately, there is no evidence of any persistence in performance beyond the randomly expected. Nor is there any demonstrated ability to identify ahead of time the very few winners. What is even worse is that the evidence over long periods is that the very few winners outperform on an after tax basis by a very small amount, and the losers underperform by a much larger amount, about three times greater. So even if you manage to pick one of the few active funds that outperforms, the odds are great that you will outperform by only a small amount. On the other hand, the odds are great that you will choose an active fund that will underperform by a large amount. No wonder Charles Ellis called active management a loser's game - it's not that you cannot win, but instead the risk-adjusted odds of winning are so low that it does not pay to play a game you are not forced to play.

One study found that for the ten-year period 1982-91, on a pretax basis, just twenty-one percent of the funds outperformed their benchmark, Vanguard's S&P 500 Index Fund. The average outperformance was 1.8 percent per annum. The average underperformance was a similar 1.9 percent. On an after-tax basis, however, only about eight percent of the funds managed to beat their benchmark. The average outperformance was now just 0.9 percent, while the average underperformance increased to 3.1 percent. Keep this in mind: the ratio of about 3.5:1 (the 3.1 percent underperformance divided by the 0.9 percent outperformance) in favor of the underachievers is made all the more significant because there were about eleven times as many losers as winners. Thus, we find that not only are there far more losers than winners, but also that the average size of the underperformance is far greater than the size of the outperformance. Therefore, we need to look at the risk-adjusted odds of outperformance. We can calculate that by multiplying the odds of outperformance by the ratio of underperformance to outperformance. Doing so gives us risk-adjusted odds against outperformance of about thirty-eight to one.

The same study then looked at the ten-year period 1989-98, and found that on a pretax basis, just fourteen percent of the funds outperformed, with the average outperformance being 1.9 percent. The average underperformance was 3.9 percent. On an after-tax basis, only nine percent of the funds outperformed. The average outperformance was 1.8 percent. The average underperformance was 4.8 percent. The risk-adjusted odds against after-tax outperformance are about twenty-eight to one.

Choosing active funds based on past performance is really being "fooled by randomness," the title of a wonderfully insightful book by Nassim Nicholas Taleb. It is also the loser's game, the triumph of hope over reason and experience. The winning strategy is to invest in tax efficient passive vehicles that provide that exposure to the asset classes in which you wish to invest.

(1) Mark Carhart, "On Persistence In Mutual Fund Performance," Journal of Finance, March 1997.
(2) Russ Wermers, Journal of Finance, (August 2000).
(3) Jim L. Davis, "Mutual Fund Performance and Manager Style," Financial Analysts Journal, January/February 2001, pp. 19-27.
(4) Richard M. Ennis and Michael D. Sebastian, "The Small-Cap Alpha Myth," Institutional Investor, Spring 2002.
(5) Robert D. Arnott, Andrew L. Berkin and Jia Ye, "How Well have Taxable Investors Been Served in the 1980s and 1990s," Journal of Portfolio Management, (Summer 2000).

05/30/2002

Larry Swedroe is the author of What Wall Street Doesn't Want You to Know and The Only Guide To A Winning Investment Strategy You Will Ever Need. His third book, Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today, was recently published by St. Martins Press.

Swedroe's latest book is a collection of 52 common investing mistakes to avoid. In an interview, Swedroe said the book reflects his growing interest in behavioral finance and his desire to help investors avoid mistakes due to lack of education. The book also updates the two predecessors with recent academic research.

Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.