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No evidence that active small-cap managers add value consistently.
Many say the market for the shares of smaller companies-so-called small-cap and mid-- cap stocks-offers greater opportunity for active management to add value than does the large-cap market. The underlying notion is that the market for small- and medium-caps is less efficient than the large-cap market, so security mispricing is more prevalent there.
It is true that fewer securities analysts follow small-- and mid-cap companies, and they are less widely held by portfolio managers. But is there evidence that active management is really more productive in the small- and mid-cap arena than in the large-cap arena?
A survey of the literature turns up no compelling evidence that managers add value with greater consistency in portfolios dominated by smaller companies. As far as we can tell, the small-cap thesis results from casual inspection of fund databases that sometimes show the majority of small-cap funds outperforming a popular index of smaller stocks over a particular period.
Three performance evaluation errors contribute to what we claim is actually a small-cap alpha myth. The first is ignoring management fees. The second is using an inappropriate benchmark. The third is ignoring survivorship effects and other biases that inflate the average return of portfolios in commercial databases. Here is an illustration of the three at work.
VANISHING ALPHAS
We constructed a sample of 128 products from the Mobius Group M-Search database-a popular database of institutional commingled funds and composites of separate accounts-that represent themselves as active small-- cap.1 As is the case with most such databases, the vast majority of the products in the sample (90%) report only gross-of-fee returns. The median portfolio in this sample outperformed the Russell 2000 index, before fees, by 4.04 percentage points per year over the ten years ending June 30, 2001.2 Four percentage points per year for the median fund is a striking margin of value added.
Fees
We calculate fees for each product in the sample according to the managers' reported fee schedules and adjust the returns accordingly. The median net-of-fee alpha is 3.09 percentage points, still a very respectable figure.3
Benchmark Misspecification
The returns of small-cap portfolios are more heterogeneous than those of large-cap portfolios. Knowledgeable analysts would not compare all large-cap products...