Can Active Small-Value Funds Save You From Index Overlap?
It's difficult to avoid index overlap entirely.
Investor Michael Burry, who was featured in the film "The Big Short" and made a killing betting against collateralized debt obligations during the 2008 crisis, recently claimed that the popularity of index funds is creating a bubble. He essentially argues that the flood of money going into equity index funds is creating liquidity risk, with the amount of money linked to many stocks through index funds out of proportion to their daily trading volume. He said that small-cap value stocks are relatively attractive because they tend to be underrepresented in indexes.
At the very least, the bulk of passive U.S. equity assets are indeed tied to large-cap-dominated indexes like the S&P 500 and Russell 1000 Index; even total-market indexes tend to be large-cap-focused. But time will tell whether Burry’s concern is well-founded. Nevertheless, his interview got me thinking about actively managed small-cap value funds and to what degree they own stocks outside of their prospectus benchmarks. That is, if a fund investor did want to avoid index overlap, to what extent could that be achieved? I looked at the 19 small-value funds that Morningstar covers as a sample.
One place to start might be a fund’s active share. The higher a fund’s active share percentage, the more distinct its portfolio is from that of the index. A high active share can be achieved by holding stocks that are not in the benchmark index, owning stocks that are in the index but weighting them differently, or some combination of the two.
But, when it comes to small-value funds, a high active share alone doesn’t tell you much. That’s because active share tends to be high for most actively managed small-value funds, especially when compared with their large-cap fund cousins. (The median for the 19 small-value funds was 89.2%.) The large-cap universe is much more concentrated than the small-cap opportunity set, which is very diffuse. For instance, 21.7% of the S&P 500's weighting is in its top 10 constituents, while the top 10 stocks in the Russell 2000 Index account for just 2.9% of the benchmark.
I looked at the percentage of a fund’s holdings that are not in its primary prospectus benchmark (that is, the distinct holdings percentage), as well as its overall active share. The accompanying table shows the results for the 19 small-value funds Morningstar covers.
In looking at the results, two things jumped out. First, there can be enormous divergence between a fund’s distinct holdings percentage and its active share. That is, you would think that having a relatively high weighting in nonindex stocks would lead to having a high active share, but that wasn’t necessarily the case.
In fact, Royce Special Equity (RYSEX) had the lowest percentage of distinct holdings (18.6%) relative to its primary prospectus benchmark (the Russell 2000 Index) but the highest overall active share of the group, 98.9%. DFA Tax-Managed U.S. Targeted Value had a high distinct holdings percentage (49.2%), but a relatively low active share relative to the Russell 2000 Value Index, 56.8%. (To be sure, these measurements reflect one point in time based on a single portfolio, so these percentages certainly change over time.)
The second striking observation is that it’s hard to avoid indexes altogether. Invesco Small Cap Value (VSCAX) had the highest distinct holdings percentage at 65.4%--and 96.8% active share--relative to the Russell 2000 Value Index, so it would seem like a promising way to avoid indexes. But its $3.2 billion average market cap (versus the index’s $1.8 billion) means that its distinctiveness comes in part from its mid-cap holdings.
So, to truly minimize index overlap, investors may have to turn to micro-caps. RBC Microcap Value (RMVIX) has a 34.2% had a distinct holdings weighting of 34.2% of assets as of June 2019 versus its benchmark, the Russell Micro Cap Value Index.
Top holding Willis Lease Finance (WLFC) has a market cap of just $360 million. It is in the Russell Micro Cap Value Index, but at a weighting of just 0.09% versus a 1.39% weighting in the fund. From an institutional-level perspective, DFA owns 16.6% of the company’s share across its various funds; whether you consider this passive or active ownership partly depends upon your perspective, but at least these assets aren’t tied to any particular index. But BlackRock (BLK), the owner of iShares, owns just 4.2% of the outstanding shares, and Vanguard just 3.5%.
To be clear, this isn’t a suggestion to buy a bunch of micro-cap stocks or even a fund that loads up on micro-caps. The broader point may be that it’s difficult to find a part of the public U.S. equity market that isn’t touched to a significant degree by index funds. Yes, simply focusing on small-cap stocks--and small-value in particular in this case--can get you away from the bulk of indexed equity assets. But to the extent that one wants to go in this direction, it would likely mean targeting fairly illiquid parts of the market such as micro-caps, which bring their own risk factors. So, be aware of the risks that come with this alternative.
Kevin McDevitt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.