Swedroe: Benchmark Smoke & Mirrors

Make sure managers claiming outperformance are using an appropriate benchmark.

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Reviewed by: Larry Swedroe
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Edited by: Larry Swedroe

As a regular contributor to and reader of Advisor Perspectives, I was scanning the headlines on its website last month, looking for articles of interest. I noted the headline, “Investing in Small-Cap-Growth Companies with a Long-Term View.”

The article, basically an interview with John Barr, who manages the Needham Aggressive Growth Fund (NEAGX), begins by noting: “As of June 30, 2018, NEAGX had an annualized return of 10.51% over the prior 15 years, versus 9.42% for the S&P 500, for an outperformance of 109 basis points.”

When I pointed out to the editor that the S&P 500 Index was not an appropriate benchmark for a fund Morningstar categorizes as having an investment style of small growth, he added comparisons to the Russell 2000 Index (its return during the period was 10.50%) and to the average return of active funds in the small growth asset class (which was 9.77%) that survived the period (there’s survivorship bias in the data). However, from my perspective, that change was insufficient. I’ll explain why.

Strange Question
To start, the interview began with a curious query: “Tell us about your approach to investing in small-cap growth stocks—a notoriously difficult asset class for active managers.”

It’s curious, because small-cap stocks are supposedly more inefficient than large-cap stocks; at least that is the claim of the active management industry. Importantly, the small growth equity asset class is known as the “black hole” of investing due to its relatively poor returns, which are attributable to the presence of “lottery stocks” (such as penny stocks, IPOs, and small growth stocks with low profitability and high investment).

Following are returns for the four major U.S. equity asset classes using Fama/French research indexes over the period July 1926 through June 2018:

  • Large Growth: 9.8%
  • Large Value: 12.0%
  • Small Growth: 8.8%
  • Small Value: 14.8%

Over the 15-year period examined in the article, the Fama/French small growth research index returned 10.3%. All an active fund had to do to outperform a small growth index was screen out lottery stocks from their eligible universe, as those stocks have had notoriously awful returns.

Barr’s response to the question about the fund’s strategy was, “I believe that finding and holding investments in compounding stocks is the path to long-term wealth creation.” He then went on to explain the type of stocks he looks for, what he called “compounding stocks” with high return on capital, and provided some examples, such as CarMax and Entegris.

Active’s Supposed Advantages

When asked about an ongoing advantage of active management, Barr cited the work of Martijn Cremers and Ankur Pareek, authors of the 2016 study “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently.” Cremers created the concept of active share, a measure of the difference of the holdings of a fund’s portfolio from the holdings of its appropriate passive benchmark index. He found that funds with high active share and low turnover tended to outperform.

Unfortunately, out-of-sample tests of active share have not found the same results. In fact, in May 2012, Vanguard’s research team looked at the issue of active share as a predictor. Its study covered the 1,461 funds available at the beginning of 2001. They found that even with survivorship bias, with proper benchmarks, higher levels of active share didn’t predict outperformance.

The study “Estimating Time-Varying Factor Exposures” by Andrew Ang, Ananth Madhavan and Aleksander Sobczyk of BlackRock, which was published in the fourth-quarter 2017 issue of the CFA Institute’s Financial Analysts Journal, provided an out-of-sample test (post 2009) of the findings from Cremers and Antti Petajisto’s first paper on active share.

Ang, Madhavan and Sobczyk found that the active share measure proposed by Cremers and Petajisto actually was negatively correlated (-0.75) to fund returns after controlling for factor loadings and other fund characteristics. Thus, the authors concluded “it is not the case that high conviction managers outperform.”

Perhaps most importantly, in an appendix of Cremers’ own paper, he found that all of the cumulative outperformance occurred in the brief period 1999 through 2001 (during which the tech bubble burst, indicating that high-active-share funds were able to sidestep it). Using the four-factor model, the high-active-share quintile’s abnormal performance was -0.36% per year with a t-statistic of -0.49. So much for active share as predictor.

Returning to Barr’s comments, he noted that while Cremers required a low turnover rate of 25%, his fund’s turnover was just 7%. In addition, the highest category of active share required a level 92% or higher and, as of June 30, 2018, NEAGX was at 110% versus the Russell 2000 Index. Thus, his fund met the criteria of both high active share and low turnover.

Digging Into NEAGX

With those facts in mind, let’s benchmark NEAGX against a more appropriate fund than the Russell 2000 Index benchmark, which is sometimes chosen by active managers because of the ease of outperforming it.

Due to the transparency of its reconstitution rules, active managers could choose to front-run the Russell 2000 Index. That creates a performance drag for funds seeking to match it. This is why Vanguard long ago abandoned that index as the benchmark for its Small Cap Index Fund (NAESX). From January 1979 through June 2018, the Russell 2000 Index returned 11.8%, while the very similar CRSP 6-10 (small-cap) Index returned 13.1%. Those results reveal an underperformance of 1.3 percentage points per year, again perhaps explaining why funds and investment consultants would choose the Russell 2000 Index as a benchmark—it makes them look good.

Morningstar classifies NEAGX as a small growth fund, and the regression analysis that I performed at Portfolio Visualizer showed this to be the case. The fund has a high and statistically significant loading on the size factor (about 0.6 with a t-stat of about 7) and a statistically significant negative loading on the value factor (about -0.2 with a t-stat of about -2.7). Therefore, I’ll compare its performance to that of the Vanguard Small Cap Growth Index Fund (VISGX). Funds are fairer benchmarks than indexes because indexes don’t have costs.

Over the same 15-year period (July 2003 through June 2018), VISGX returned 11.49%, outperforming NEAGX by 0.98 percentage points. It also had a slightly higher Sharpe ratio, 0.62 versus 0.61. If we extend the period to the longest for which we have data (September 2001 through July 2018), we find that NEAGX returned 9.53% and VISGX returned 10.30%. Thus, NEAGX produced a return 0.77 percentage points lower than an appropriate passive fund benchmark.

Reasons For Underperformance

You don’t have to dig very deep to uncover the source of NEAGX’s underperformance. Because its turnover is very low, the answer is not in the fund’s trading costs. Rather, the reason NEAGX underperforms lies in its expense ratio of 2.63%. VISGX has an expense ratio of just 0.19%, or 2.44 percentage points lower. The Admiral Shares version, VSGAX, has an even lower expense ratio of just 0.07%.

The way to think about this is that any benefit from the manager’s stock-picking skill went to the fund’s sponsor, not the shareholders. That likely explains why NEAGX has less than $60 million in assets under management, while VSGAX has about $24 billion.

The bottom line is that, despite being able to screen out lottery stocks in the small growth asset class and having the so-called advantage of a high active share with low turnover (which Cremers claimed led to outperformance), NEAGX underperformed simple indexing strategies.

It’s certainly possible that you can mine the data to identify a small percentage of actively managed funds that have outperformed appropriate risk-adjusted benchmarks, but the evidence, including this example, demonstrates how difficult a game active management is to win. It’s why Charles Ellis called it a loser’s game, meaning it’s one best not played.

The article also shows why it’s important to understand how active funds can make themselves look good by choosing the easiest-to-beat benchmark. This game of choosing inappropriate benchmarks is played not only by actively managed mutual funds, but also by investment consultants.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.