The odds may be better for small-cap managers, but they're still long.
Imagine you've entered a poker tournament and have the choice to sit at one of two tables. Seated at table one are enthusiastic newbies you surmise as being likely to show their hands, bluff badly, or make otherwise unwise bets. At the second table are players you recognize as contestants from the World Series of Poker. You might relish the challenge of taking on the latter, but playing the amateurs instead of the pros would maximize your chances of winning.
The table of amateurs offers what the insightful strategist, author, and professor Michael Mauboussin calls "the easy game." Easy games are those whose players aren't very skilled, and the payoff from winning is high.
Games like these have become scarce in investing, Mauboussin argues, because less-informed investors have moved to passive investments, leaving the most skilled investors to compete against each other. Technology, both because it promotes transparency and can be used to efficiently sniff out market anomalies, has also helped make investing a harder game to win.
If there are still easy--or at least easier--games in the public markets, we might expect to find them in the small-cap arena. It's not that small-cap investors are any less skilled than their large-cap counterparts. Their playing field is bigger and less crowded than in large caps. Small caps account for a tiny slice of the stock market's total value, but there are 3 times as many small-cap stocks as large caps, according to data from O'Shaughnessy Asset Management. Wall Street doesn't pay much attention to these names: The O'Shaughnessy paper notes that 40% of small caps are covered by three or fewer analysts, and 20% have no analyst coverage at all. By contrast, 27 analysts follow the typical mega-cap stock. The largest stocks are more liquid and therefore attract more assets from institutions. Such neglect should leave more under-exploited opportunities in small caps than in the large caps.
On the other hand, similar forces have been at play in small caps as in large caps. Over the past five years, passive funds' share of small-cap assets rose from 29% to 46%. (Passive large-cap funds' share grew from 35% to 48% over the period.) The tide of passively managed dollars should push out less-capable small-cap managers just as they would large-cap managers. The game for small-cap managers could be just as tough.
Small Caps: The Easier Game?
The Red Sox would more likely run up the score against the Yankees' minor-league club than against the Yankees themselves. That's because the two major-league clubs are more evenly matched. A contest against less-skilled minor-leaguers is the easy game. Similarly, if small caps offer more opportunity than large caps, we might expect the best-performing small-cap funds to outperform by greater margins than the best-performing large-cap funds. Put another way, small-cap funds should have an easier time running up the score.
To test this proposition, I divided the active U.S. equity fund universe into large-, mid-, and small-cap buckets using return data from August 1997 through July 2017 on a gross-of-fees basis. The data set includes a single share class from every fund in existence over the 20-year period--nearly 4,800 in all. (Including all funds, not just the ones that are still around today, limits the impact of survivorship bias in the data. I limited my study to 20 years because the sample size shrinks dramatically beyond this point, especially in small caps--a fact that suggests the space has gotten a lot more crowded over the past couple of decades.) I viewed the difference, or dispersion, of returns between the best and worst performers across market-cap buckets through two lenses. I first sliced the data into rolling-one year periods to examine the historical trend. Because one-year periods can be noisy, I broke the two-decade stretch into five-year increments to get a longer-term perspective. I calculated the dispersion of returns between the 20th and 80th return percentiles to mute the impact of extremes.
The technology-fueled insanity of the late 1990s and its hangover in the early 2000s created massive disparities, especially in mid- and small caps, between the best- and worst-performing funds, as Exhibit 1 vividly illustrates. That this gap would shrink was inevitable. Such extremes, at least of the late-1990s variety, are historical anomalies. Had I started the clock in 2002 instead, the story would be less dramatic, but it would tell a similar tale. The trend continued to slope downward--a sign the game for active managers continued to get progressively harder.