In September 2018, our team wrote a paper on market efficiency entitled “Reinventing the Core,” which established a framework for assessing the relative merits of active management in different equity universes. In it, we identified the US small-cap equity universe as one of the more inefficient markets and one where active management has historically generated strong alpha. What our 2018 paper didn’t address was how best to invest in small caps. The purpose of this paper is to pick up where the last one left off, exploring important factors to consider when allocating to US small-cap stocks and devising a framework for overcoming the universe’s unique challenges and pursuing the alpha opportunity.
In particular, we share our research on three key issues:
- Why get active: A look at the potential of active management in US small-cap stocks.
- How to pursue the alpha opportunities: Thoughts on how active managers can add value by avoiding “junk” and holding on to “graduates.”
- Ways to build an allocation: Trends in the active small-cap space and key considerations when building an investment program.
Why get active: Exploiting a breadth of opportunities
In their 1999 book Active Portfolio Management, Grinold and Kahn popularized the concept of the Fundamental Law of Active Management. They developed a formula that defines risk-adjusted returns as the product of investor skill and the breadth of the opportunity set (or, said differently, the number of independent bets an investor makes). The implication is that investors can improve their results by either improving the quality of their decision making (skill) or increasing the number of bets they make. With this idea in mind, we believe the US small-cap market is very attractive for alpha generation because of two unique characteristics:
- It is relatively inefficient, which can potentially make it easier for active managers to achieve better results.
- The breadth of opportunities is high, and therefore there’s a wide opportunity set to which investor skill can be applied.
There are a variety of ways to measure breadth. Using the S&P 500 and the Russell 2000 indices as proxies for large- and small-cap opportunity sets, the Fundamental Law of Active Management says there is twice as much breadth in small caps as there is in large caps. To complement this, we also looked at several other characteristics to help assess breadth, including return dispersion, index concentration, and the concentration coefficient.
Return dispersion
While the number of stocks is an input into the Fundamental Law of Active Management, it is a static concept. Therefore, we also looked at the dispersion of returns across the small-, mid-, and large-cap universes, which introduces volatility and the passage of time. Our intuition is that, all else being equal, the more differentiation between the performance of stocks in a universe, the more opportunity there is to beat the benchmark. As shown in Figure 1, there is a clean ranking of dispersion across the cap spectrum, with small cap having the highest dispersion and large cap the lowest.
Equity Market Outlook
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