Trading Strategy Keys Success for Small-Cap Funds

For small-cap funds, trading execution can be almost as important as stock-picking. The trading volume for small caps is much less than mid- and large-cap stocks, so there can often be a wide gap between the bid price and ask price. Thus, trading acumen can have a big impact on what price a fund receives when it buys or sells a stock, and it can further impact that price by driving it up or down as the fund buys or sells.

In September I visited the main offices of one of the best small-cap traders around: Dimensional Fund Advisors. The Santa Monica firm was founded to invest along principles established by research done by Eugene Fama and Kenneth French. Their studies found that small-cap stocks have higher risks and higher returns than larger-cap stocks. By investing in a diversified basket of these stocks, one could tone down the risks while still enjoying the gains.

Thus, Dimensional created a suite of small-cap funds that are passively managed in a fashion similar to index funds. However, what I find really interesting is the way these funds diverge from index funds.

Before I get any further, I should make it clear that if you haven't heard of Dimensional already, you probably can't get into its funds. It's not by invitation only, but it's close. The funds are geared toward institutional investors but increasingly they've been made available to financial advisors who share Dimensional's philosophy of low-cost passive investing. To gain access, planners must attend workshops on the funds and meet Dimensional's screens aimed at weeding out those who like to actively trade among funds. The firm wants to try to minimize the presence of fickle investors in its funds. Unpredictable cash flows could disrupt its ability to trade efficiently, which is a big part of its competitive advantage.

Although access is limited, there are some helpful lessons to be drawn from Dimensional's work even if you can't buy its funds. Here are some answers to questions you might have.

How much of a difference can trading strategies make in small-cap investing?
Glad you asked. Dimensional's funds are passively managed in that they don't try to select stocks. However, they are different from index funds because they don't try to track an index. Rather they aim to own a wide array of stocks in a market-cap range and let trading opportunities guide their stock purchases.

Dimensional aims to be the market-maker of last resort. If someone is eager to sell or buy a stock and they are willing sell at a discount or buy at a premium, Dimensional steps in. The firm estimates that this strategy adds about 2 percentage points (or 200 basis points) of value. Now think about who's on the other side of that trade. A momentum fund would be buying when everyone wants to buy and selling when everyone wants to sell. That would make the momentum fund a price-taker, meaning it sometimes would drive stock prices in the opposite way that it wants. But in all it's a zero-sum game: If Dimensional's trading is adding 200 basis points, there are doubtless many small-cap funds whose trading is subtracting 200 basis points.

Is the small-cap market less efficient than large caps?
The performance of actively managed small-cap funds versus small-cap index funds would lead you to believe small-cap land is quite inefficient. Despite its big cost advantage, Vanguard Small Cap Index (NAESX) has been beaten by three quarters of all small-cap blend funds over the trailing 10 years. That's amazing.

I think small-cap markets probably are less efficient, but those figures can be misleading. Consider the performance of Dimensional U.S. Small Cap (DFSTX) which, not coincidentally, has bested Vanguard Small Cap Index's 10-year returns by about 200 basis points annualized over the past 10 years. It doesn't suffer from the problems that have plagued funds tracking the Russell 2000. Those funds have to make costly small trades to keep in sync with the index. In addition, the annual Russell index rebalancing has been a feast for arbitrageurs because they can easily figure out which stocks are leaving and which are entering the index and trade ahead of the changes. So part of that underperformance is due to steep trading costs rather than market inefficiencies.

Dimensional U.S. Small Cap has actually beaten about 60% of small blend funds over the trailing 10 years. That's not as strong as  Vanguard 500 Index's (VFINX) dominance of its competition: That fund has beaten more than 80% of large-blend funds over the trailing 10 years. So the small-cap market may well be less efficient than the large-cap, but beating a sound passive fund like Dimensional's is no sure thing.

What should I look for in a small-cap fund?
The index funds' experience shows how important trading can be to a small-cap fund. When looking for a good small-cap fund, look for one with a good trading strategy and some expertise in small caps. Small-cap specialists like Wasatch and Royce come to mind. Low turnover funds are better, but if you do consider a high-turnover fund, be sure to look into its trading strategy and its advisor's assumptions about asset growth. Rapid-trading small-cap managers forfeit some of their ability to trade nimbly as assets increase.

I'd also suggest keeping an eye on the aforementioned Vanguard Small Cap Index. Yes, it has been roundly beaten, but some recent improvements should make it a tougher competitor. Vanguard index head Gus Sauter is no dummy. He shopped for a better small-cap index that had lower turnover and fewer dramatic changes than the Russell 2000 used to have. Last year Vanguard switched to a new-and-improved index, the MSCI U.S. Small Cap 1750.

Is Arnold Schwarzenegger passive?
He appears to be when it comes to investing. The Gubinator owns a minority stake in Dimensional.

What's more exciting: Dimensional's funds or the view from Dimensional's offices?
Definitely the view. While Dimensional practices a sleepy, passive investing style, it has an awesome view of the Pacific Ocean and Santa Monica Beach.