The Small Cap Alpha Myth Revisited

Transcription

1 The Small Cap Alpha Myth Revisited January 2016 Risk. Reinsurance. Human Resources.

2 Executive Summary This white paper revisits a white paper published by our organization in 2001 that challenged the widely held assumption that the U.S. small cap equity market is more attractive for active management than the U.S. large cap equity market. Our updated research resulted in a conclusion consistent with our research in The median active U.S. small cap strategy generated less alpha during the 10-year period ending June 30, 2015 than it did during the original research period. The difference in transaction costs (including commission rates and implementation shortfall) between large cap and small cap stocks has not materially changed over the past decade. Returns from many databases are inflated by factors such as survivorship, selection, and backfilling data biases. When incorporating these database biases as well as style biases into the universe returns, the excess return for the median manager across all three universes (U.S. Small Cap Growth, U.S. Small Cap Value, and U.S. Small Cap Core) are negative over the 10-year period analyzed. Small cap alpha is further reduced, and negative for all styles, when measured against small cap benchmarks other than the Russell small cap suite of indices. Active management in public equities is an exceptionally difficult endeavor, regardless of capitalization size. We believe that certain high-conviction active managers have the best odds of adding value, but investors should not be under the illusion that active management in small cap equities is easy money. 1 Introduction In 2001, our organization published a white paper titled The Small Cap Alpha Myth 2 that challenged the widely held assumption that the U.S. small cap equity marketplace is more attractive for active management because it is less efficient than the large cap marketplace. Fourteen years after the initial paper was published, it is time to revisit our initial analysis to determine whether changes have taken place over the past decade. Small Cap Alpha Generation Our initial research, conducted in 2001, evaluated the previous 10-year period and observed attractive alphas (+4% gross of fees) generated by U.S. small cap managers when reviewed within a broad universe of peers relative to the Russell 2000 Index. However, when fees and benchmark misspecification were factored in, the original research showed that the alpha was reduced to 1.2%. However, even that result was likely inflated by survivorship and backfilling in the database suggesting that the true alpha was much smaller, and possibly even negative. 1 Sebastian and Attaluri. Conviction in Equity Investing. Journal of Portfolio Management 40(4) (2014). Available at capital consulting/retirement/investmentconsulting/bin/pdfs/jpm_summer_2014_aon.pdf. 2 Ennis, Richard M. and Michael D. Sebastian. The small cap alpha myth. Journal of Portfolio Management 28(3):11 6 (2002). The Small Cap Alpha Myth Revisited 1

3 Investment manager data is easier to obtain and analyze 14 years later with the growth of widely used manager research databases such as evestment. When looking back over the 10-year period ending June 30, 2015, we find a much different picture with respect to performance results. Below are the results we evaluated over the past 10 years as of June 30, 2015 using evestment s style-specific universe data (U.S. Small Cap Growth, U.S. Small Cap Value, U.S. Small Cap Core) in order to reduce benchmark misspecification issues. Chart 1. Net of Fees 10-Year Annualized Excess Returns Over Russell Style-Specific Benchmarks as of June 30, % 2.0% 1.0% 0.0% Universe Median 25th Percentile -1.0% Small Cap Growth Small Cap Value Small Cap Core The excess return generated by the median U.S. Small Cap Value manager is similar to that of the original research; however, the excess returns generated by the median U.S. Small Cap Growth and U.S. Small Cap Core managers are much lower than those of the original research. In all instances, the top quartile manager over the past 10 years has produced considerably better results (approx. +1 percentage point) than the median manager. That said, we recognize that databases such as evestment have some inherent selection bias. Selection bias is a result of self-reported manager returns, which naturally leads to those managers with attractive returns being the most willing to report their results to the database. Additionally, investment managers are able to backfill returns into evestment without any restrictions. The results shown above do not take into consideration these biases that are inherent in the data. In the following sections, we incorporate additional considerations into the analysis. Additional Considerations: Liquidity/Transaction Costs/Database Biases Our initial research did not stop with the evaluation of relative performance, but also looked at the impact liquidity, transaction costs, and database biases had on small cap managers. We recognize that liquidity and transaction costs are already incorporated into the returns for the managers, but have analyzed this data in an effort to determine whether market dynamics have changed since the initial research was conducted. The Small Cap Alpha Myth Revisited 2

4 Liquidity Liquidity within the small cap universe of stocks has increased since our original research in Trading volume measured as the average daily dollar volume of each security within the Russell 2000 Index has increased from 2001 (from approximately $1.5 million per day to over $4.5 million per day in 2014). However, this is drastically off the peak of over $7 million per day reached during 2007, and is further offset by the increase in the value of the overall small cap market since This increase in trading volume, though, has not offset the dramatic increase in assets being managed within small cap strategies including the meaningful amount of exchange-traded fund (ETF) strategies that have entered the marketplace over the past decade. The small cap study produced by Stephen DeSanctis and Christina Giannini estimates that assets within small cap mutual funds (including ETFs) have grown to over $500 billion, in addition to an equal amount that is privately managed. 3 Transaction Costs The use of electronic and high frequency trading have both increased over the past decade. Yet the total transaction costs for trading large cap securities, when compared to small cap securities, continues to produce a meaningful differential when analyzing the ITG Global Cost Review 4 data (measuring both commission rates and implementation shortfall). This spread has narrowed during periods of strong market liquidity for small caps, but the differential has tended to remain in the basis point range for much of the past 10 years. Survivorship Bias Survivorship bias continues to be an issue that impacts universe comparisons for all active managers. Survivorship bias tends to lead to an overstatement of historical returns because of the closing of poorly performing funds, and to the tendency of investment managers to stop reporting returns when they experience poor performance. Looking at the 10-year period ending June 30, 2015, we observe considerable change within the small cap universe data. 3 DeSanctis, Steven G. and Christina Giannini. Capacity Study More Funds Closed in Small Cap Growth. Bank of America Merrill Lynch Small Cap Research, August 21, Investment Technology Group, ITG Peer Analysis. Global Cost Review, The Small Cap Alpha Myth Revisited 3

5 Chart Year Period Ending June 30, Small Cap Growth Small Cap Value Small Cap Core 50 0 Number of managers submitting returns at beginning of period Number of managers submitting returns for entire period The number of strategies that were discontinued or merged into another strategy, or that simply stopped reporting performance to the database during this 10-year period, is significant. While most institutional investors rarely experience the liquidation of an existing investment strategy, the number of strategies that disappear from the database has a meaningful impact on the universe returns. By analyzing quarterly return data from evestment for both active and inactive strategies, we can estimate the impact of survivorship bias within the U.S. small cap universe data. 5 For the annualized 10-year period ending June 30, 2015, we estimate survivorship bias of approximately 62 basis points (0.62%), 45 basis points (0.45%), and 48 basis points (0.48%) for the U.S. Small Cap Growth, U.S. Small Cap Value, and U.S. Small Cap Core universes, respectively. Backfill Bias Backfill bias is another issue self-reporting databases face that influences the reliability of universe comparisons. Managers that do not report returns at the time of a strategy s inception tend to subsequently report to a database only if a successful track record has been established. Given this, and given that underperforming strategies are usually never reported at all, databases that allow data to be backfilled tend to reflect inflated performance results. For the annualized period ending June 30, 2015, we estimate a backfill bias 6 of approximately 15 basis points (0.15%), 20 basis points (0.20%), and 26 basis 5 Survivorship bias was estimated by taking the difference between 1) the median return of only the funds in the universe that had reported returns for the entire 10 year period and 2) the median return using all available data points in the universe, including funds that had reported returns for only a portion of the 10 year period. 6 Backfill bias was estimated by first gathering each fund s inception date and date the fund was added to the database in order to calculate the median lag time for each universe. The results were as follows: 10 quarters for the Small Cap Growth universe and 15 quarters for the Small Cap Value and Core universes. The backfill bias was estimated by taking the difference between the quarterly returns including and excluding the first 10 and 15 quarters of the respective universes. The Small Cap Alpha Myth Revisited 4

6 points (0.26%) for the U.S. Small Cap Growth, U.S. Small Cap Value, and U.S. Small Cap Core universes, respectively. The table below illustrates the realized alpha after adjusting for these inherent data biases. When incorporating survivorship and backfill biases into the results for the 10-year period ending June 30, 2015, the median U.S. Small Cap Growth and U.S. Small Cap Core managers produced negative excess returns (-1.0% and -0.4%, respectively), and the median U.S. Small Cap Value manager produced a positive excess return of only 0.8%. Chart 3. Net of Fees Median 10-Year Annualized Excess Returns Over Russell Style-Specific Benchmarks as of June 30, % 1.0% 0.5% 0.0% -0.5% Universe Median Including Survivorship Bias Including Backfill Bias -1.0% -1.5% Small Cap Growth Small Cap Value Small Cap Core The data above suggests that U.S. Small Cap Value is the only segment of the actively managed U.S. small cap universe that might have achieved positive excess returns over the 10-year period. The differential, however, between investing in a top quartile small cap manager versus those with performance results similar to the median has been significant over the past 10 years. This emphasizes the importance of identifying managers that truly have skill in selecting stocks and building actively managed portfolios within the small cap space, as was demonstrated in the 2014 Journal of Portfolio Management. 7 7 Sebastian and Attaluri. Conviction in Equity Investing. Journal of Portfolio Management 40(4) (2014). Available at capital consulting/retirement/investmentconsulting/bin/pdfs/jpm_summer_2014_aon.pdf. The Small Cap Alpha Myth Revisited 5

7 Chart 4. Net of Fees 25 th Percentile 10-Year Annualized Excess Returns Over Russell Style-Specific Benchmarks as of June 30, % 2.5% 2.0% 1.5% 1.0% 0.5% 25th Percentile Including Survivorship Bias Including Backfill Bias 0.0% -0.5% Small Cap Growth Small Cap Value Small Cap Core Index Considerations Thus far, excess return data has been evaluated versus the respective standard style and capitalization Russell indices. We utilized Russell indices in our updated analysis for two reasons: one, to provide an apples-to-apples comparison with our 2001 research; and two, because Russell is among the most utilized and widely accepted small cap index providers, if not the top index provider in the small cap space. In order to measure excess performance over even more appropriate style- and size-specific benchmarks, we used a returns-based style analysis that identified each strategy s effective style mix (ESM) benchmark. The ESM benchmarks are each comprised of a unique allocation of the 12 major Russell equity-style indices that produce the highest possible correlation with the strategy s monthly returns. These benchmarks provide a better metric for assessing a manager s skill in producing excess returns from style and size rotation and/or security selection. We used each strategy s ESM benchmark rather than the standard Russell 2000 style benchmarks to analyze excess performance over the 10-year period. The results shown in the following chart are much more dire, with each universe median manager showing negative alpha after accounting for the data s biases. Further, this analysis still does not account for selection bias, which leads to inflated returns since products added to databases tend to be the best-performing ones. The Small Cap Alpha Myth Revisited 6

8 Chart 5. Net of Fees 10-Year Annualized Excess Returns Over ESM Benchmarks as of June 30, % 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% Universe Median Including Survivorship Bias Including Backfill Bias -0.8% -1.0% -1.2% Small Cap Growth Small Cap Value Small Cap Core Finally, research suggests that the predictability of index changes provides an opportunity for arbitrage activity. The index study produced by Honghui Chen, Gregory Noronha, and Vijay Singal found that Russell 2000-linked index funds lose between 1.30% and 1.84% due to arbitrage around index changes. 8 This also impacts small cap active management s perceived success, given that 98% of small cap active strategies within the evestment universe are benchmarked to the Russell indices. When alpha is measured using small cap benchmarks other than the Russell small cap suite of indices (CRSP, MSCI, Wilshire, and S&P), the results, after taking into account survivorship and backfill biases, are negative for all styles over the 10-year period ending June 30, Conclusion The widely held assumption that inefficiencies within the U.S. small cap equity market should lead to greater opportunity for active management than the large cap equity market appears to be just as mythical in 2015 as it was in The growth in actively managed assets within the small cap space over the past 14 years may be significantly contributing to the lack of inefficiency that many market participants erroneously assume. Active management in public equities is an exceptionally difficult endeavor regardless of capitalization size. We believe that some high-conviction active managers are likely to add value, but investors should not operate under the illusion that active management in small cap equities is easy money. Consistent with our conclusion in 2001 and subsequent research, we believe broad-based passive management within U.S. equities makes sense for most investors. 8 Chen, Honghui, Gregory Noronha, and Vijay Singal. Index Changes and Unexpected Losses to Investors in S&P 500 and Russell 2000 Index Funds. Social Science Research Network, March The Small Cap Alpha Myth Revisited 7

9 Contact Information Katie Comstock Senior Consultant Aon Hewitt Investment Consulting, Inc Chris Riley Associate Partner Aon Hewitt Investment Consulting, Inc The Small Cap Alpha Myth Revisited 8

10 About Aon Hewitt Investment Consulting, Inc. Aon Hewitt Investment Consulting, Inc., an Aon plc company (NYSE:AON), is an SEC-registered investment adviser. We provide independent, innovative solutions to address the complex challenges of over 480 clients in North America with total client assets of approximately $1.8 trillion as of December 31, More than 280 investment consulting professionals in the U.S. advise institutional investors such as corporations, public organizations, union associations, health systems, endowments, and foundations with investments ranging from $1 million to $310 billion. About Aon Hewitt Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement, and health solutions. We advise, design, and execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability, and wellness. Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information, please visit aonhewitt.com. Aon plc All rights reserved. Past performance is no guarantee of future results. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Hewitt Investment Consulting s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Aon Hewitt Investment Consulting disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Hewitt Investment Consulting reserves all rights to the content of this document. The Small Cap Alpha Myth Revisited 9