Small caps: It pays to index

Hammering away at the misconception that it pays to seek active managers in supposedly "less efficient" sectors like small caps, S&P Dow Jones' Philip Murphy finds - even choosing among the top mutual fund share classes - an alarmingly small number of managers failed to beat the benchmarks.

Starting at the March 2009 bottom and going out five years, only 9 of 139 share classes  beat the S&P SmallCap 600 benchmark (that's 5.9% of the starting set).

Where alpha might be able to be delivered though, is in choosing which benchmark to track. A fund tracking the S&P SmallCap 600 (IJR, VIOO) would have outperformed one tracking the Russell 2000 (NYSEARCA:IWM) by 23% over the 5-year period.


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Comments (13)
  • mjtroll1
    , contributor
    Comments (2793) | Send Message
    excellent observation..when observing the ijr/iwm pair trade their is clear upward bias (ijr outperform) and their is a positive skew to upside deviations.. currently near middle of -3/+6 range at 2.3
    25 Jul 2014, 02:39 PM Reply Like
  • hound1965
    , contributor
    Comments (59) | Send Message
    Small caps outperform large caps over the long term. That's been known for a while. As a whole actively managed funds under perform the index. John Bogle has been preaching that for three of four decades now.
    25 Jul 2014, 02:49 PM Reply Like
  • Market Trends Investor
    , contributor
    Comments (1266) | Send Message
    (NYSEARCA:RWJ) and (NYSEARCA:EES) beat just about everybody in the small cap corner.
    25 Jul 2014, 03:01 PM Reply Like
  • Tschurin
    , contributor
    Comments (381) | Send Message
    If you selectively limit your time period to only when the stock market is going up, you obviously will find that many actively-managed funds will do less well, if for no other reason than the drag on performance from keeping part of the portfolio in cash. Over the complete market cycle, the story is probably different.
    25 Jul 2014, 03:13 PM Reply Like
  • Petrarch
    , contributor
    Comments (1148) | Send Message
    actually it is not. it is the same. pick any period. in fact because many underperforming active funds are just shut down there is a survivor bias.
    and still the indexes are the way to go.


    someone will always beat the index. however it is not always the same guy - unless it is Buffet - and there is only one of him - and beating it one year does not mean that you will not just give it all back and then some the next.


    25 Jul 2014, 04:03 PM Reply Like
  • Mike Spelman
    , contributor
    Comments (85) | Send Message
    The irony is that indexing makes Seeking Alpha more or less a moot point. It's interesting reading people's opinions on individual stocks, but at the end of the day my 401k is 100% SPY. Roth is about half indexed, half AAPL, HAL, AFL and AIG
    25 Jul 2014, 05:22 PM Reply Like
  • Tschurin
    , contributor
    Comments (381) | Send Message
    "actually it is not. it is the same." Those short declarative sentences might fool someone into thinking that they had the truth of data behind them but I don't think so. Take any period? OK. 2008, when the market was going down. Principia says that roughly 80 of 180 "small cap blend" funds outperformed the ishares russell 2000 ETF. 80 out of 180 is a lot more than the 9 out of 139 the S&P person cites. My point is not that it is easy to outperform the indexes. The point is that it is misleading to pick a period when the market is only in a bull market rebound for a meaningful comparison of actively-managed versus the index.
    25 Jul 2014, 06:10 PM Reply Like
  • Petrarch
    , contributor
    Comments (1148) | Send Message
    Do the work and really take a look at it.
    Sure you can can cherry pick pick a year or a day - so what. If you use an investor's real world time horizon you will get my conclusion.


    Here's the point.


    There are are least two problems.


    Problems 1 and 2. Making the wrong decision.


    let us take your 2008 as an example. wonderful news. great 80 beat the market -


    1. For this information to be useful you need a way to be able to find these 80 before the beginning of the period. So you need a way of identifying. So far there isn't one.


    2. Further you wonder what happened in the year prior an post. at the end of the day it is the market timing fallacy. you think it should be easy to buy low and sell high but clearly it is not.


    So you have two problems two solve and you need to get them right because the fees and the chance of being wrong as well as the transaction costs of moving in and out will erode and then some the benefit of the active hunting strategy relative to buying and holding cheap index funds.


    Next Problem. The Agency Problem.


    With an index you know what you are getting. With a Managed fund you have an agent who may or may not stick to the mandate or have the necessary skill or gumption to fully execute it. Index funds do not have this problem to anything like the same extent.


    The Free Rider Benefit. Of Indexing.
    But there is more. If you own the index - you own the market. The market is basically the opinions of all the participants. If active managers believe a stock is undervalued - you will benefit - without having to pay for the privilege. A Free Rider benefit. What's not to love?


    This is an easy argument. If you are not persuaded, no matter to me. But the logic is pretty clear.


    26 Jul 2014, 06:26 PM Reply Like
  • Petrarch
    , contributor
    Comments (1148) | Send Message
    Correct. Seeking Alpha is an excellent branding slogan but in reality a mirage.


    Most investors do not achieve Beta, let alone Alpha.


    We hear a lot about picking stocks but the real value comes in building a portfolio with a level of convexity (a term normally heard with bonds but can apply to stocks) and diversified across asset classes. This is the most important problem.


    This is something which moves up when the market goes up - perhaps slightly less and moved down when the market goes down - again slightly less. You don't need to buy puts or sell calls or do anything fancy to do this. You can achieve a level of convexity by buying indexes which moves at different rates. A barbell e.g. US Value and International Small will work. Or US Growth and US REITS or US Small Cap and US Utilities. Etc. Ofcourse Bonds are always important an should be included.


    Do this and you can achieve a rate of increase about the same as SPY but at a lower level of volatility - that should be your goal.


    26 Jul 2014, 06:35 PM Reply Like
  • supaflix
    , contributor
    Comments (23) | Send Message
    You picked 1 year? Short time frame means more variability. Anyone can get lucky once but can they get lucky consistently in up and down markets?


    Change it to any 5 year period and the percentage of active funds beating indexing will decrease. Change it to a 10 or 15 year period and you will see that number decrease farther, possibly to zero. This is not new information.
    26 Jul 2014, 08:14 AM Reply Like
  • keu4bike
    , contributor
    Comments (453) | Send Message
    What about game theory and the meta game.


    As the fraction of money in the market that is indexed increases, the index advantage diminishes. You need the non-index trade to inform the index trade. In a highly indexed market, almost the only way to beat the market is to pick stocks. In an unindexed market, indexing is a good way to beat the market.


    As I watch the market, I see too many occasions where stocks and bonds are moving together when I think they ought to be moving opposite. I wonder how much of this is due to indexing, modern portfolio theory, allocation, and 401(k)s on auto-pilot. I'm sure other factors are also at work, but I wonder if this is contributing.
    26 Jul 2014, 10:34 PM Reply Like
  • David Jackson
    , contributor
    Comments (1279) | Send Message
    There's an *excellent* article by Ploutos which explains why IJR outperforms IWM:
    8 Sep 2015, 02:38 PM Reply Like
  • Mirkoj
    , contributor
    Comment (1) | Send Message
    "even choosing among the top mutual fund share classes - an alarmingly small number of managers failed to beat the benchmarks"
    I guess he meant an alarmingly high number of managers...
    5 Dec 2015, 10:23 AM Reply Like
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