| Active
vs. Passive Management for Small-Cap Funds
By Jim Wiandt
March 19, 2001 |
|
"Active management works better than passive index funds
for small-cap and international funds."
This notion is so widespread that it has become conventional
wisdom in financial circles. I have never seen much to back it
up, and have largely held an agnostic view on the subject. In
this study, we take a look at small-cap funds.
We attempted to address some of the issues that have dogged active/passive
studies in the pass. First, we looked at investable returns, not
index returns. We chose benchmark index funds to measure the performance
of the field, and of course only included small-cap funds in our
survey, eliminating the natural bias that exists when, for example,
you compare the large-cap performance of the S&P 500 with
a relatively small-skewed group of mutual funds.
How did it come out? Well, the active funds lost. Basically,
if you'd chosen a small-cap index fund (there are very few), you'd
have beaten the active field in almost any time period in the
study. I must admit that the results surprised me to some degree.
I was fully prepared for an active rout given the tremendous advantage
we hear that active funds have in researching small companies.
I was even ready to publish the results - we just want to tell
it like it is.
Here's the way it is:
- Over the eight 3, 5, 10, and 15 year periods covered by the
study, a majority of active funds lost to their index fund counterparts
on seven occasions.
- Over the past ten years, passive index funds have outperformed
their active opposites eight years (with one tie).
In the year-end
study we did surveying the mutual fund industry, I at least
compiled enough evidence to be convinced that there was a lot
of apples vs. oranges comparison going on. Active vs. passive
analysis, across all equity sectors, tends to change over different
time periods, based more on sector performance than actual fund
performance.
Even the seminal charts put together by John Bogle in his books
suffer from this problem. This can be clearly seen from the wild
swings in numbers from year to year. Take a look at this chart
that Saint Jack put in his latest book, for instance. It compares
the returns of the S&P 500 to those of the field of equity
funds:
In years when large has had a good run, most mutual funds get
crushed by the S&P 500 (very much a large-cap) index. Look
at the late 1990s. On the other hand, when other market segments
(small-cap of course being one of these) are outperforming large
U.S. stocks, the numbers dip to less than 50 percent losing to
the S&P 500.
For a nominally more fair evaluation, see the chart comparing
all funds to the Wilshire 5000. It's in Bogle's first book, Bogle
on Mutual Funds. Because of the representation of the total
market, it is a better approximation. And the more moderate numbers
on both sides speak to this. Still, the fact that only around
15% of funds have beaten the total market over the 5-year, 10-year
and 15-year periods through 2000 is clearly not a pretty site.
Nonetheless, style preference and style drift of funds still make
this a less-than-ideal comparison.
The other point of contention is that on average one expects
the total return of funds to equal market minus costs. Even the
vaunted Vanguard 500 fund does not beat its index on TOTAL return.
With dividends figured in to index returns, over time the Vanguard
fund lags the S&P 500 index by in the neighborhood of 10-20
basis points (0.10%-0.20%), though the Vanguard 500 has actually
outperformed the index with creative fund management over the
past three years. Minus taxes, returns fall off some more.
Here are the criteria we used to determine which funds were used
in the study and how they were compared.
Broad Criteria
- Institutional funds with minimum initial investment of $25,000
or greater were eliminated.
- Funds that are closed to new investment were eliminated.
- Funds with less than one year of history through 12/31/2000
were eliminated.
- For the small-cap comparison, only funds that fell in the
Morningstar style boxes 7-9 were used. (7 being small value,
8 small blended, and 9 small growth).
- For the small-cap growth comparison, only funds from style
box 9were included.
- For the small-cap value comparison, only funds from style
box 7 were included.
Benchmark Criteria
- Benchmark had to be from the appropriate style box for the
category (style box 7-9 for small, style box 7 for small value,
and style box 9 for small growth).
- Benchmark had to be a passive index fund.
- Benchmark had to be an investable fund (not closed, not institutional,
and currently available for purchase by U.S. retail investors).
- Benchmark had to have sufficient history to be included, wherever
possible (for small value, there was no index fund with any
history of longer than three years. Also, many style and size
ETFs were launched in 2000, and while they do not have the track
record to be included in the study, may ultimately prove to
be worthy category benchmarks. Vanguard also now has low fee
small growth and value index funds).
- Benchmark with the lowest expense ratio was chosen as category
benchmark once all other criteria were met.
| Benchmark
Selections |
| Category |
Fund
Name |
Ticker
Symbol |
Expense
Ratio |
| Small
Cap |
Vanguard
Small Cap Index Fund |
NAESX |
0.25% |
| Small
Cap Growth |
Galaxy
II Small Company Index Fund |
ISCIX |
0.41% |
| Small
Cap Value |
Bridgeway
Ultra-Small Index Fund |
BRSIX
|
0.75% |
Following is a brief survey of the results. All data is from Morningstar
as of December 31, 2000.
Part I: Small-cap active funds vs. Vanguard Small Cap Index
Fund (NAESX)
Benchmark Returns are Annualized.
Morningstar Data as of 12/31/2001
The study arrived at similar results for both small growth and
small value categories as well. Though the available data for
those sectors was more narrow, the results were nearly as conclusive.
Of the data set (1-year, 3-year, 5-year and 10-year for small
growth and 1-year and 3-year for small value) passive funds won
in 4 of 6 time periods. For a complete outline of the data, please
refer to The
Index Insider, the Index Funds subscription-based newsletter.
In summary, it seems that the cardinal rule that drives index
investors to common sense holds true for small-cap funds. That
is, high costs/ high expenses are the best determinant of underperformance
for a mutual fund. These costs, brought on by research expenses
and trading costs, coupled with the tax consequences of high-turnover
active management, force a fund's manager to outperform the benchmark
by its alpha minus the fund's costs if outperformance of the benchmark
is the desired end.
