Small-Cap Funds Struggle With Asset Bloat

Small-cap stocks have been on a strong upward trajectory, as measured by the Russell 2000 Index, since the market’s bottom in March 2009 through June 30, 2018, earning an annualized return of 19.6%. These strong returns outpaced the broader market, as measured by the S&P 500’s return of 18.4% over the same period. However, the effect has been significant market-cap appreciation, raising the concern that some small-cap managers that have remained open to new investors may be capacity-constrained and drifting into mid-cap territory.

The Russell 2000 Index had an average market cap of about $613 million in March 2009 relative to about $33 billion for the S&P 500. As of June 2018, the former has appreciated to over $2 billion while the latter stands at about $99 billion. The small-cap index’s 216% appreciation in average market cap from March 2009 through March 2018 is substantial. Two of the funds highlighted below,

Of the 96 unique funds with Morningstar Analyst Ratings in the small-growth, -value, and -blend Morningstar Categories, 64 remain open to new investors. Nonindex funds in the category range in size from $74 million in assets under management up to $25 billion. The largest strategies are index funds:

One such example is Bronze-rated Vanguard Explorer, which had $15.1 billion in AUM as of June 30, 2018. While its portfolio size affords it some extra capacity, holding more than 500 names, its average holding has recently crept into mid-cap territory, as seen by its ascension in the Morningstar Style Box and holdings’ average market cap of over $5.3 billion versus active small-growth peers’ average of $3.0 billion. Its average market cap is more than double that of the Russell 2000 Index. Further, its relatively low active share of about 70% suggests that managers may be having difficulty differentiating it from the benchmark. Investors should be cognizant of the fund’s mid-cap exposure as they incorporate the strategy into a broadly diversified portfolio.

Another fund that remains open to new investors despite an asset base in excess of $10.8 billion is Bronze-rated Neuberger Berman Genesis. While it has run the strategy with an asset base above $10 billion for 10-plus years, its burgeoning size bears watching. Similar to the other strategies highlighted, this fund boasts an above-average exposure to mid-cap growth names, over 56% of the portfolio relative to active peers’ average of 43%. Its average market cap of about $3.9 billion is well above the Russell 2000 Index’s about $1.8 billion and active peers’ average of $3.0 billion. While its low-turnover approach facilitates trading in the small-cap space, its buy-and-hold mentality results in the appreciation of names into mid-cap territory, and its portfolio of about 125 names falls well below active peers’ average of more than 170 holdings.

The aforementioned funds have continued to deliver for investors but have done so with above-average exposure to mid-cap stocks relative to peers. Investors considering these investments as a way to gain small-cap exposure should be cognizant of the challenges that come with growing AUM, including a tendency to drift higher on the market-cap spectrum because of increased difficulty trading in more illiquid, or smaller, stocks. Further, while the examples illustrated here have successfully navigated a large asset base, both bear watching to ensure that management is not straying from their core competencies as they become more capacity-constrained.

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