Small-Cap Distortions: Is There Hope for Active Managers?

The small-cap segment of the U.S. equity market has long been viewed as a sweet spot for active portfolio management. A large, diverse pool of stocks, a lack of research coverage and relatively illiquid securities have contributed to inefficiencies ripe for exploitation by skilled stock pickers.

Still, in recent years, it has become increasingly difficult for active managers to outperform in the small-cap space. In part, this seems a function of a marketwide shift in focus to macro issues since the 2008 crisis, as stocks have moved more in tandem in reaction to broad economic developments. However, it appears to us that something more is at play—the distorting influence of aggressive Federal Reserve policy and the growth of passive small-cap exchange-traded funds (ETFs). In this paper, we look at these issues and their ramifications. Despite recent headwinds, we come away with reasons for confidence in the prospects of long-term oriented active managers in the small-cap space.

Recent Performance Trends

The relative performance record of active small-cap mutual fund managers has been fairly bleak post-2008, as shown in these displays. Based on Morningstar data, rolling periods of various lengths all indicate a downward trend in the percentage of active smallcap core managers who have been able to outperform the Russell 2000 Index. Although survivorship bias and the inclusion of fees may have some influence on these figures, these biases should apply across all time periods. We saw similar results across the broader smallcap category when comparing growth and value managers to the Russell 2000.

Source: Morningstar.

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