Download Active management can add big value in small

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
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