Lazzara: Indexing Can Capture Small-Cap Premiums

Dan Sotiroff: Hi, everyone. I'm Dan Sotiroff, here at the 2017 Morningstar ETF conference. And I'm joined today by Craig Lazzara of S&P Dow Jones Indices.

Craig Lazzara: Delighted to be here, thank you.

Sotiroff: I wanted to ask you a few questions regarding small-cap stocks. Over the past few years we've seen that there's a lot of new work coming out regarding the existence of small-cap premium, whether or not it really exists. Is small-cap investing something that investors should still be looking at?

Lazzara: Absolutely. There are a couple ways to justify that view, I think, Dan. One is simply the history of the data, which go back really to the beginning of the Ibbotson Sinquefield Database in, I think, 1926, if you look at the returns of small-cap stocks versus the S&P 500, for example, as a representative of large-cap stocks, there is a persistent small-cap premium. Even more recently the work we've done and others have done, say the S&P 600 small-cap index routinely--not every year of course, not persistently but routinely--outperforms the S&P 500 big cap, large-cap index. So, very commonly the return exists or the premium exists. And that's something investors rightly are concerned about how to capture.

Sotiroff: So it still works, just not all the time and so forth.

Lazzara: Not all the time. When somebody tells you something works all the time, just hold on to your wallet and back away as easily as you can.

Sotiroff: Fair enough, fair enough. So at more of a practical level, as an investor, why should I consider (index) options in the small-cap space? I guess one of the things I've always heard is that the small-cap space is a little less efficient and active managers can kind of take advantage of that.

Lazzara: There's a really interesting subtlety that you raise. If you define market efficiency as the presence of lots of research analysts or trading volume, it's certainly true that small caps are less efficient in that sense. Now what that means is, that because there are fewer analysts looking for misvaluations in the small-cap world than there are in say looking at IBM or Microsoft or Apple, there are fewer analysts covering small caps, logically what that means is that the possibility of misvaluation is higher for small caps than it is for large caps. That's not to say that the possibility of undervaluation is higher, it's just that the possibility of misvaluation is higher.

And in order for there to be a good case to say that you should always use active management in the small-cap realm, you'd have to make an argument for persistent undervaluation. That's kind of the theoretical view. The practical view is if you look at studies for example, SPIVA study, S&P Index versus Active Data, which compare the performance of active managers to appropriate benchmarks, routinely the active managers have at least a hard a job outperforming the S&P 600 small cap as large-cap mangers do outperforming the S&P 500. Roughly, depends on the year obviously, but recently as many as 80% of large-cap managers and small-cap managers have underperformed their benchmarks. So it's not that it's easier in the small-cap realm.

Sotiroff: There is still evidence there, for indexing. Regarding some of the other factors in the small-cap space. You see things like low volatility, momentum, etc. Are they stronger, weaker, different in the small-cap space?

Lazzara: They are. They are present and they're typically stronger, and I say that in the following sense. The way to intuit that I think is through a measure that we call dispersion. Dispersion measures, crudely speaking, just the standard deviation of returns among the members of an index. So if returns are quite tight around an index, say the S&P 500, dispersion will be low. If returns are spread out in a given period then dispersion will be high. So for example, in 2014 dispersion was at record lows. It's recovered a little bit since then. Years like 2001, when dispersion's really high when technology is doing one thing, everything else doing something else. So that's kind of intuitively what dispersion is.

Now the reason dispersion is interesting for investment managers is that it gives you a way to gauge the level of opportunity. In a high dispersion environment the potential benefit of either good stock selection or a factor selection is much higher than in a low dispersion environment. Now, typically, in fact routinely, what we observe is that dispersion in the S&P 600 small cap index is higher than dispersion for the S&P 500. So what that means is that stock selection, if it's good, will pay off more for small caps than large caps. Parenthetically of course, stock selection, if it's bad, will hurt you more in small caps than large caps. And the same is true for factor selection. So if you're in an environment when low volatility is going to do well, you'd expect to see it do better in the small-cap realm than the large,cap realm.

Sotiroff: Alright, very good stuff. Craig, thanks again for joining us.

Lazzara: Delighted to be here Dan, thank you.

Sotiroff: For Morningstar, I'm Dan Sotiroff.