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You can’t accuse Vanguard of tilting at windmills, but perhaps you could say that they don’t ignore what they see as the man behind the green curtain. Most recently, in one of its studies, the fund provider took on the popular premise that small-cap managers outperform their benchmarks because of inefficiencies in the small-cap market and exposed it as a myth.

The report asserts early on: “Active equity management is a zero-sum game before costs and a negative-sum game after costs.” This is one of the foundations of Vanguard’s investment philosophy and is largely supported by the data presented.

The conclusions of the report attribute the supposed outperformance of active small-cap managers to benchmark selection and a specific time period. The report also discounts the idea that skill rather than luck drives said outperformance.

The study acknowledges the outperformance of small-cap managers over time when measured against the Russell small-cap indexes. Compared with the Russell small-cap value (NYSEARCA:IWN), growth (NYSEARCA:IWO) and blend (NYSEARCA:IWM) indexes, the average small-cap active manager achieved 1.7% excess returns before costs (0.3% after costs) from 1984 to 2005, the Vanguard report says. More impressively, active small-cap growth funds outperformed their Russell benchmark by 2.6% before costs (1.0% after costs).

However, all is not what it seems. Vanguard tackles the importance of benchmark selection in this report and suggests that much of the supposed alpha generated by small-cap fund managers could be attributed to mismeasurement. The Russell small-cap indexes tend to be the preferred benchmarks when measuring the performance of small-cap funds because of their comprehensiveness and long history. However, Vanguard points out their supposed “deficiencies” in the report, namely the once-a-year reconstitution (versus quarterly for most index families) and the fact that growth and value designations are determined using fewer criteria than other index families.

Russell rebalances once a year in June. Because it is a broad index, this means that underperforming stocks that would drop out over the course of a year, mainly from the small-cap index, if a quarterly rebalance was used actually remain to drag on the index. Of course, this works both ways, as outperforming stocks that would otherwise be moved up to the large-cap index from the small-cap index remain as well.

Russell also uses a fairly simple methodology for determining growth and value designations, basing the classification on book value and the I/B/E/S forecast long-term growth mean. Meanwhile, MSCI uses five factors, Dow Jones uses six and Standard & Poor’s uses seven. The report notes that return differentials between the indexes can be sizable, most significantly for small-cap growth. For the purposes of the report, Vanguard chose to use the MSCI indexes, which produced the most divergent fund performance results from the Russell indexes, for comparison. The average return differential between the MSCI and Russell small-cap growth indexes for a nearly 13-year period was a rather dramatic -4%. Vanguard has several funds based on MSCI indexes.

Even at the core level of simple small-cap index comparisons, the indexes differ. It can be difficult to exact comparable data about the actual indexes, but the discrepancies can be measured by proxy. For instance, you can compare the Vanguard Small Cap ETF (NYSEARCA:VB), which tracks the MSCI 1750 Smallcap Index, with the iShares Russell 2000 (IWM) ETF, which tracks the (small cap) Russell 2000.

According to Morningstar Principia, through May 30, IWM had a higher P/E ratio (19.9 vs. 18.3), higher P/B ratio (2.4 vs. 2.3) and a lower yield (1.01 vs. 1.16). In essence, IWM had a growth tilt compared to VB. Year-to-date, that growth tilt has helped VB outperform: the Vanguard product has posted 6.38% returns, vs. 3.72% for IWM.

Despite the recent outperformance of the MSCI fund, one of the findings of the Vanguard report is that small-cap manager outperformance over the most recent 20-year period occurs mainly around the time of the stock market bubble and its subsequent collapse, 1998–2001. And while the funds outperform the Russell indexes in other time periods, costs often drag investors’ net returns below those of the index, the report says.

Focusing further on the 1998–2001 period, the report seeks to uncover the reasons for the outperformance of small-cap managers at that specific time. While the most common explanation is that it was simply a good environment for investing, the report speculates that it was merely a good time to hang on to and purchase outperforming stocks, particularly for small-cap growth managers. By controlling for momentum investment strategies, the report found that style-adjusted alpha declined dramatically, with net alpha falling into negative territory.

The report attributes the momentum-based returns to the annual Russell reconstitution, discovering significant outperformance by small-cap growth fund managers around that time period annually. Repeating the process using MSCI indexes shows the median small-cap fund underperforming an MSCI-based indexing strategy after costs.

The report takes on another aspect of the luck-versus-skill controversy by investigating the persistence of the performance of small-cap fund managers who outperform. Interestingly, the data indicates that a randomly chosen small-cap value fund has a slightly better chance (51.8%) of generating positive alpha before costs than a fund that registered positive alpha the previous year (50.4%). Similar findings of greater magnitude resulted when using two nonoverlapping three-year periods. Small-cap funds that generated positive alpha over the preceding three years were significantly less likely than another randomly chosen small-cap fund to generate positive alpha over the next three years. Presumably, the report indicates, if a manager’s outperformance were due to skill, it would be more likely to recur.

The study, “Evaluating Small-Cap Active Funds,” was published by the Vanguard Investment Counseling & Research group and written by Joseph Davis, Ph.D.; Glenn Sheay, CFA; Yesim Tokat, Ph.D.; and Nelson Wicas, Ph.D.