Active Management Lags In Small-Cap Equity

by: S&P Dow Jones Indices

By Hamish Preston

Small caps have a reputation among many market participants as being an inefficient asset class that lends itself to active management. But our S&P Indices Versus Active (SPIVA) scorecards have repeatedly challenged this perception. Exhibit 1 shows that in 13 of the last 17 calendar year periods, the majority of actively managed, small-cap U.S. equity funds failed to beat the S&P SmallCap 600.

Exhibit 1: Most Small-Cap U.S. Equity Funds Have Underperformed Each Year

More recently, our latest U.S. SPIVA results show a whopping 72.88% of small-cap U.S. equity funds underperformed the benchmark in the 12-month period ending June 30, 2018. While these results may appear perplexing, particularly as small-cap was one of the best-performing asset classes in the same period (the S&P SmallCap 600 rose 20.50%), the choice of benchmark can help to explain the record of relative performance.

The S&P SmallCap 600's profitability screen made it a more difficult benchmark to beat.

Historically, there has been a significant difference in returns between profitable and non-profitable companies. For example, cap-weighted portfolios comprising U.S. small-caps with at least four trailing quarters of positive EPS (Group 1) outperformed those without a history of positive EPS (Group 2) between 1994 and 2014.

Exhibit 2: A Positive Earnings Screen Boosted Performance

Source: "A Tale of Two Benchmarks: Five Years Later", Brzenk and Soe, March 2015

A simple, yet effective, strategy would have therefore been to screen for profitability, which the S&P SmallCap 600 does. Compared to less-discerning small-cap benchmarks, this profitability screen has typically offered an annual performance pick-up of around 2%, making the S&P SmallCap 600 more difficult to beat. For example, while nearly 73% of small-cap U.S. equity managers underperformed the S&P SmallCap 600 in the 12-month period ending June 30, 2018, 63.84% failed to beat the Russell 2000 index.

As a result, understanding the choice of benchmarks used in our semi-annual SPIVA scorecards can help to explain relative performance figures. Indeed, an understanding of the S&P SmallCap 600's profitability screen can add color as to when and why active U.S. small-cap equity managers have, or have not, been able to outperform.

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