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There is a common misconception about “alpha” in the small-cap market within the United States. Many professionals believe that once we step out of the mega-cap world of companies like Google, Wal-Mart, Coca-Cola and Apple where there is an army of analysts digging into the vast amounts of data and pricing stocks accordingly, that there is opportunity in its smaller counterparts given the perceived market inefficiency. The story goes that there are fewer analysts covering these particular companies and, therefore, there is an opportunity to produce superior risk-adjusted returns. Whenever we want to research a particular topic in investing, it is always best to start looking into peer-reviewed academic research. In fact, we published an article all the way back in 2001 that covered this particular topic. Our analysis was based on a research paper entitled “The Small Cap Myth” produced by Richard M. Ennis and Michael D. Sebastian of Ennis Knupp Associates, one of the largest pension consulting firms in the country. Based on a sample of 128 small-cap managers, they concluded that once we adjusted for (1) management fees, (2) improper benchmarking, and (3) survivorship bias within the sample, the average “alpha” fell to virtually zero. Aon Hewitt, another large consulting firm, recently published its own research on the small-cap “alpha” myth in January of this year entitled “The Small-Cap Alpha Myth Revisited.” Based on the eVestment Database of small-cap equity managers, the researchers found that the median performance of these managers was worse for the 10-year period ending June 30, 2015 than the original analysis in 2001. The median performance across all styles in the small-cap market was less than 1% (originally around 4%). Once the researchers adjusted for survivorship bias, back-fill bias, liquidity and transaction costs, which the researchers estimated to be almost 200 basis points, the median results were actually negative. Click to enlarge Similarly, we can compare the average performance of all 479 actively managed small cap funds (as classified by Morningstar) against commercial benchmarks like the Russell 2000 Index and S&P Small Cap 600 Index. If we then add small-cap index funds from Dimensional, Vanguard and iShares, we have a nice comparison chart over the 15-year period ending 12/31/2015. As you can see below, the average actively managed small-cap fund underperformed the Russell 2000 Index by 0.24% per year and the DFA U.S. Small Cap Fund by 2.0% per year, net of fees. These results not only highlight the ” arithmetic of active management ” that Nobel Laureate Bill Sharpe reminds investors of, but also the potential benefits of utilizing a strategy, such as the one offered by DFA, that can better capture the small size premium by designing their own DFA small-cap index that has a smaller weighted average market capitalization than other indexes. Click to enlarge How can different index funds produce significantly different performances if they are all targeting the same asset class? In short, differences in performance come from differences in indexes. For example, the Russell 2000 Index focuses on the bottom 2000 companies in terms of market capitalization in the Russell 3000 Index. DFA, on the other hand, defines its Small-Cap Index as a market-capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the eligible market ( see details here ). The eligible market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions include non-US companies, REITs, UITs and Investment Companies and companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. You can find an even more detailed explanation of the historical composition of their indexes in the footnotes below. It is an important reminder that DFA is not new to the indexing industry. In fact, it is one of the pioneers of understanding and implementing index-based strategies. There is no “right” answer, but DFA’s approach seems to better capture the small-cap premium. It is a delicate balance between maintaining strong diversification, pursuing the small cap premium, and keeping trading costs as low as possible. The chart below displays the historical annualized return and standard deviation for a few DFA and Russell Indexes over the last 37 years. You can see that DFA generates a higher return than Russell by better capturing risk premiums in the stock market. Click to enlarge In its own words, Aon Hewitt summed up belief in the small-cap “alpha” with the following: “The widely held assumption that inefficiencies within the U.S. small- cap equity market should lead to greater opportunity for active management than the large-cap equity market appears to be just as mythical in 2015 as it was in 2001. The growth in actively managed assets within the small-cap space over the past 14 years may be significantly contributing to the lack of inefficiency that many market participants erroneously assume.” We couldn’t agree more. Click to enlarge IFA Painting: The Size Premium Disclosure: I am/we are long DFSTX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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