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Active Small-Cap Managers Add Value: Myth or
Reality?
By Larry Swedroe,
Contributing Writer
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.
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