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Principal Global Equities Active management can add big value in small-cap equities Brian Pattinson, CFA - Portfolio Manager Key points: Inefficiencies create opportunity Our approach to active investing is grounded in a powerful idea: compelling investment opportunities emerge from inherent inefficiencies. The small-cap universe is a corner of the market with inherent inefficiencies that can be exploited through fundamental analysis and stock selection. While the value and effectiveness of active management has been debated among investors, consultants, advisors, and academics for some time, the growth and expansion of passive investment options including index funds and exchange-traded funds (ETFs) over the past decade has added a new twist to the discussion. The question at the forefront of small-cap equity investor’s minds is Has the growth of passive investments diminished the small-cap opportunity set? Active managers can be more selective Active managers are able to add value by being more selective in their investment choices. They can also have the advantage of including firms that are not included in passive investment strategies. Active share is positively correlated to excess alpha Our research indicates that active share positively correlates to excess alpha over time. This is especially important in the small-cap universe, which is much broader and more evenly distributed than the largecap universe. In this paper, we address this topic and some of the points that support why Principal Global Equities, along with many institutional investors and consultants, continue to embrace active management and advocate it over a passive approach to small-cap stocks. Opportunities arise from inherent inefficiencies Our approach to active investing is grounded in a powerful idea: compelling investment opportunities emerge from inherent inefficiencies. Therefore, less-efficient areas of the market will offer even more-abundant opportunities. The small-cap universe spans a broad, fragmented opportunity set that is unfamiliar to many investors and is prone to neglect. This results in a plethora of inefficiencies for active managers to exploit through fundamental analysis and stock selection. Greater opportunity for stock pickers to add value The irony of the “active-versus-passive” debate — and something we find many investors often fail to recognize — is that passive strategies can actually add to market inefficiencies, particularly within small cap. After all, passive strategies are not static portfolios. Rather, passive strategies continuously buy and sell stocks as quickly as possible, in order to stay “true” to their indices. Active management can add big value in small-cap equities 1 For example, a typical Russell 2000 index fund generates 15% to 20% turnover per year, simply because of index rebalancing. ETF index funds also experience significant turnover. For example, one popular Russell 2000 ETF with over $38 billion in assets had a daily trading volume that exceeded $3.8 billion (data as of December 30, 2016). 1 When investors buy these index funds, regardless of market-cap or style focus, they are blindly “buying in bulk.” In other words, they are not discriminating among stocks. • Such forced buying and selling to rebalance these passive portfolios creates anomalies, noise, and inefficiencies at the margins. • One such result is that the increase in passive trading volumes naturally leads to higher correlations between individual companies. • This sets the stage for active management. An active manager with a disciplined investment process can sort through the disparate universe of small cap stocks, identify the best candidates and make precise portfolio decisions. Furthermore, active managers are not limited just to their indices for investment opportunities. There are hundreds of out-of-the index small-cap firms that are outside the realm of passive strategies, such as New issues Spin offs Restructurings Most notably “fallen angel” companies that simply slide into the small-cap zone between index rebalances are examples of such opportunities. The small-cap advantage The small-cap advantage is evident when reviewing the historical outperformance of active managers versus the index. This holds true for both U.S. and non-U.S. when comparing small-cap to large-cap universes. To take this a step further, it is also evident when comparing the universe median versus the index. Exhibit 1: There’s a clear historical advantage in small-cap equities. % Outperforming index U.S. NonU.S. Universe median vs Index Benchmark eVestment Universe 3 yrs 5 yrs 10 yrs 3 yrs 5 yrs 10 yrs S&P 500 US Large Cap Equity 25% 36% 62% -1.11% -0.62% 0.37% Russell 2000 US Small Cap Equity 55% 62% 77% 0.45% 0.80% 1.27% US small vs large advantage 31% 26% 16% 1.56% 1.42% 0.90% MSCI World ex-US Large Cap ND EAFE Large Cap Equity 80% 88% 84% 1.09% 1.76% 1.22% MSCI World ex-US Small Cap ND EAFE Small Cap Equity 76% 92% 87% 1.48% 3.17% 1.73% International small vs large advantage -4% 4% 3% 0.39% 1.41% 0.51% Source: eVestment Alliance Data shown as of 30 December 2016. For additional information, please refer to the disclosure section. Active management can add big value in small-cap equities 2 We are often asked “How active and different is your manager?” We suggest this question “How top-heavy is your benchmark?” To get a sense for how top-heavy the index is and how much overlap is likely to exist for portfolios managed against each, you can look at the concentration of the top-ten holdings of various indices. As Exhibit 2 illustrates, the small-cap universe is not as top-heavy as large-cap indices. Overall, there is less index concentration making it easier to have an active share that is different than the benchmark. Exhibit 2: Less concentration of an index’s top-ten holdings means a high active share is easier to achieve. 25% The small-cap universe is much broader, and more evenly distributed, than the large- cap universe. Less overlap with benchmarks (i.e., higher active share) provides active managers increased ability to add value. 20% Index weight 15% 10% 5% 0% S&P 500 Russell 2000 MSCI Japan MSCI Japan Small MSCI Europe MSCI Europe Small MSCI EM MSCI EM Small MSCI ACWI MSCI ACWI Small Source: S&P 500, Russell, MSCI Data shown as of 30 December 2016. For additional information on MSCI, please refer to the disclosure section. Active management can add big value in small-cap equities 3 Small-cap benchmark mechanics also lend an inherent advantage for active managers Characteristics of the benchmark Tend to be diversified (not top-heavy) Active small-cap managers also gain an inherently valuable advantage from the mechanics of small-cap benchmarks. In order to outperform an index, a portfolio needs to be different than the index. To this point, we believe the active-share ratio is an important measure. Active share measures aggregate differences in portfolioholding weights versus the benchmark-constituent weights. More specifically, our research indicates that active share effectively measures the excess-return potential of a portfolio and positively correlates with excess alpha over time. Benchmark: Large-cap Inherently easier to construct high active-share portfolios Benchmark: Large-cap A hypothetical example will better illustrate the top-heavy nature of large-cap benchmarks. Assume a manager wants to take a 1.5% overweight position in the largest stocks in the S&P 500 and the Russell 2000. As the chart below illustrates, taking the same overweight position leaves the manager with a 4.7% weight in the large-cap index stock, but a 1.9% weight in the small-cap one. Example scenario Small-cap Small-cap Greater potential for active manager to add value Benchmark: Large-cap Small-cap Index S&P 500 Russell 2000 Largest stock Apple (AAPL) Advanced Micro Devices Inc. (AMD) Index weight 3.21% 0.45% An investment manager takes the same overweight position in the company. 1.50% 1.50% Investment in stock 4.71% 1.95% Source: S&P 500, Russell 2000. Data shown is as of 30 December 2016. Chart shown is for illustrative purposes only. It takes more than twice the portfolio allocation to achieve the same overweight position in large-cap versus small-cap. This is a 2.76% difference, that the manager can use to invest outside the benchmark holdings to maximize alpha potential. Active management can add big value in small-cap equities 4 Exhibit 3: Small-cap portfolios achieve a consistently higher active share, regardless of the number of stocks in a portfolio. Active share ratio 100% Stock count – often used as a crude measure of a portfolio’s activeness – has a much more dramatic effect on the active share of portfolios managed against a large-cap index than a small-cap index. 75% 50% 25% 0% 25 50 100 250 500 Portfolio stock count MSCI World Ex-US Small Cap Russell 2000 MSCI World Ex-US S&P 500 Source: S&P 500, Russell 2000, MSCI Data shown as of 30 December 2016. For additional information on MSCI, please refer to the disclosure section. A strong case for active management The case for active management of equities and long-term investment portfolios remains strong, despite the recent growth in passive investment strategies. The small-cap universe is particularly compelling given its size and the limited availability of research. This provides active managers the opportunity to generate alpha beyond what passive strategies can provide. Perhaps, it is no surprise that large-cap and mid-cap managers often buy small-cap exposure from outside their benchmark in an effort to reduce overlap, increase activeness, and bolster alpha potential. About Principal Global Equities Principal Global Equities is a specialized investment management group within Principal Global Investors. We are fundamental investors, focused on bottom-up stock selection, providing client-focused investment solutions spanning equity markets worldwide. We are distinguished by a globally integrated culture that embraces collaboration, the unified adherence to a distinctive bottom-up stock selection investment philosophy and process, and the ways we leverage technology to consistently and effectively manage portfolios and client relationships. 1 Morningstar Direct. Data shown as of 30 December 2016. Active management can add big value in small-cap equities 5 Disclosures Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of January 2017. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision. The information in this document contains general information only on investment matters. It does not take account of any investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account. Principal Financial Group, Inc., Its affiliates, and its officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any error or omission in this document or in the information or data provided in this document. Any representations, example, or data not specifically attributed to a third party herein, has been calculated by, and can be attributed to Principal Global Investors. Principal Global Investors disclaims any and all express or implied warranties of reliability or accuracy arising out of any error or omission attributable to any third party representation, example, or data provided herein. All figures shown in this document are in U.S. dollars unless otherwise noted. Indices are unmanaged and do not take into account fees, expenses and transaction cost and it is not possible to invest directly in an index. This document is issued in: • The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission. • Europe by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London EC2V 7JB, registered in England, No. 03819986, which has approved its contents, and which is authorised and regulated by the Financial Conduct Authority. • Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act (Chapter 289). • Australia by Principal Global Investors (Australia) Limited (ABN 45 102 488 068, AFS License No. 225385), which is regulated by the Australian Securities and Investment Commission. • This document is issued by Principal Global Investors LLC, a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organization. This document is intended for sophisticated institutional and professional investors only. In the United Kingdom this presentation is directed exclusively at persons who are Eligible Counterparties or Professional Clients (as defined by the rules of the Financial Conduct Authority). In connection with its management of client portfolios, Principal Global Investors (Europe) Limited may delegate management authority to affiliates who are not authorized and regulated by the FCA. In any such case, the client may not benefit from all the protections afforded by the rules and regulations enacted under the Financial Services and Markets Act 2000. This material is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. Small and mid-cap stocks may have additional risks including greater price volatility. Investing involves risk, including possible loss of principal. Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Principal Securities, Inc., 800-547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc., and Principal Securities are members of the Principal Financial Group®, Des Moines, IA 50392. ©2017 Principal Financial Services, Inc. Principal, Principal and symbol design and Principal Financial Group are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company. Principal Global Investors is the asset management arm of the Principal Financial Group. Principal Global Equities is a specialized investment management group within Principal Global Investors. MM7834-01 t1701230afu