Small Cap Paradox?

April 14, 2006

Small cap active managers claim to be the exception to the “indexing wins” argument. But that claim is slipping away…

Proponents of active investing love to pull out data on small cap funds to show that active management can add value.  The argument is seductive because it makes intuitive sense:  1) Indexing works best in an efficient market; 2) The small cap market is inefficient because the stocks are underfollowed and under-analyzed; 3) Actively managed funds can add value by capitalizing on these inefficiencies.

And the thing is that active fund proponents do have some data to back them up.  Neuberger Berman, the fund and asset management arm of Lehman Brothers, argues that both active and passive management have their place in an investor's portfolio. They cite data from Morningstar to prove their point:

For the five years ending December 31, 2004, actively managed small-cap blend funds returned an annualized 12.51%, compared to an average annual return of 6.61% for the Russell 2000 Index.

You see data like that cited everywhere, from the Wall Street Journal to articles by indexing know-it-alls like Matt Hougan. Active outperformance in the small cap arena has been called indexing's "small cap paradox."

The trend is so pervasive that active small cap fund managers are actually starting to put their money where their mouth is.  The invaluable Fund Alarm newsletter reported this month on a new small cap fund from TFS, whose fund managers are so convinced they will beat theirbenchmark (the Russell 2000) that they have put their management fee on the line.  The TFS Small Cap Fund will charge investors 1.25 percent per year, but only if it outperforms the Russell 2000 by at least 2.5 percent per year.  For every 2 basis points below "Russell+2.5%," the TFS Small Cap will drop its expense ratio by 1 basis point.  If the fund simply tracks the Russell index, the expense ratio will be zero (where the give away stops, regardless of performance). On the flip side, of course, if the fund outpaces the Russell, it gains 1 basis point for every 2 basis points it beats the index, up to a maximum expense ratio of 2.5 percent.

That's a refreshing approach by an active fund manager, and I applaud it.  But are they really so bold?  Or is their choice of the a benchmark - the Russell 2000 - a case of setting the bar low enough to make it easy to clear.

Recent research is shining new light on the apparent small cap paradox.  The emerging consensus is that active fund outperformance is not a result of active managers sorting through an inefficient marketplace, but of an inefficient rebalancing system taxing the performance of the dominant small-cap benchmark, the Russell 2000.  Choose another small cap benchmark and the outperformance largely disappears.  And even with the Russell 2000, that negative rebalancing impact could be on the way out.

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