Does Active Management Succeed in International Small-Caps? by Royce Funds
Divergent conclusions about the relative success of active management in the international small-caps universe prompted us to do our own examination, which stresses the importance of choosing the appropriate benchmark and evaluating the consistency of a fund’s performance over long-term time periods.
In the international small-cap space, research coverage is limited and information is disseminated less efficiently.
Divergent conclusions about the relative success of active management in the international small-cap universe prompted us to do our own examination, which stresses the importance of choosing the appropriate benchmark and evaluating the consistency of a fund’s performance over long-term time periods.
The chart below provides a revealing picture of just how underfollowed, and thus how rich in potential opportunity, the international small-cap universe is.
Small-Cap Uncovered
Most International Small-Caps Receive Little or No Research Coverage
Source: FactSet
Research coverage counts are based on the number of analysts who provide earnings estimates.
There have been two recent studies that explored this topic. In the summer 2013 issue of the Journal of Investing, Abhay Kaushik of Radford University published a study entitled, “Performance and Persistence of Performance of Actively Managed U.S. Funds that Invest in International Equity” where the author examined a universe of 570 actively managed international funds over a 20-year time period from 1992-2011.
This study found that the fund average for both total returns and risk-adjusted performance, as measured by the Sharpe ratio, was higher than the benchmark averages in nine out of 13 international categories.
We were particularly interested in the results for the foreign small-caps and mid-cap growth and value categories where Kaushik used the Morningstar analyst indexes as benchmarks to evaluate these actively managed universes.
While the non-U.S. small-cap value category did not boast returns as high as their growth counterparts, they did outperform their assigned benchmarks in this study, indicating a clear advantage for active management during the period measured.
More recently, Abby Woodham, a fund analyst on the passive funds research team for Morningstar, published an article entitled, “Passive vs. Active: Debating International Small Cap” on Morningstar.com.
Woodham’s examination of all mutual funds from Morningstar’s foreign small-caps and mid-cap categories came to a different conclusion, finding that the categories were “littered with underperforming funds.”
She created a data set of all actively managed mutual funds in Morningstar’s foreign small-cap and mid-growth, value, and blend categories. She then calculated the group’s average alpha relative to the MSCI EAFE Small Cap Index using three-year return data through 5/31/13.
She found that the average alpha produced by the active funds over the past three years was 0.02, or almost zero. Investors picking from the broad list of international small-cap funds would have a less-than-50% chance of selecting an outperforming fund.
Seeing the variance in performance patterns over time helps to show the significant opportunity set that exists in the large number of non-U.S. small-cap stocks. Regions and countries do not move in lockstep; like sectors and industries, they have cycles with generally unpredictable movements that disciplined active managers seek to use to their long-term advantage.
These divergent conclusions about the relative success of active management in the international small-cap arena prompted us to do our own examination.
We too constructed a universe of active international small-cap funds using Morningstar Direct. We selected all funds in the Morningstar Foreign Small- and Mid-Growth, Blend, and Value categories and then eliminated all fund of funds, index funds, and enhanced index funds and then limited representation to the oldest share class for each fund. This resulted in a universe of 80 funds (76 with at least one-year of history).
A variable that is often overlooked in the heat of the active versus passive debate is the choice of the benchmark, something that turns out to be particularly key in the international small-cap space.
While Kaushik used the MSCI ACWI ex USA SMID Indexes, Woodham used the MSCI EAFE Small Cap Index. At Royce, we benchmark our international offerings with the Russell Global ex-U.S. Small Cap Index, so we looked at all three benchmarks for the trailing periods.
Below we have a snapshot comparison of these three international small-cap indexes that shows wide divergence in performance.
Trailing Returns Show Wide Divergence in Near-Term Performance
Average Annual Total Returns as of 6/30/14
Over the last one- and three-year trailing periods ended June 30, 2014, the MSCI EAFE Small Cap handily outperformed the MSCI ACWI ex USA SMID and Russell Global ex-U.S. Small Cap Indexes.
While the median active foreign small/mid fund outpaced the MSCI ACWI and Russell Global ex US Indexes, it trailed the MSCI EAFE Small Cap Index. However, the median active foreign small/mid fund outperformed all three indexes for the trailing five-year period.
In addition to using trailing periods, as is most commonly done, we also chose to evaluate rolling one-, three-, and five-year returns because we believe that these offer a more effective and in-depth measure of performance. We began in January 2001, the inception of the MSCI EAFE Small Cap Index, which was the index used in the Morningstar study.
Looking at rolling periods changed the results markedly. In contrast to the results reported in the Morningstar study, which measured a single three-year period, our rolling results found that the median active foreign small/mid fund outperformed the MSCI EAFE Small Cap Index in 80% of all monthly rolling five-year return periods and in 62% of all monthly rolling three-year return periods.
Our research raised an important question: Why were the rolling returns for the MSCI EAFE Small Cap Index so different?
As opposed to single point-in-time comparisons, rolling returns account for the fact that most investors do not typically invest at the beginning of a given one-, three-, or five-year period but instead invest over many periods.
We believe this makes rolling returns more revealing than point-in-time results anchored by the end of the month or quarter.
Thus, instead of making the assumption that an investment was made on January 1, rolling returns calculate all of the one-, three-, and five-year periods starting not only in January, but also in February, March, April, etc.
This method allows an investor to evaluate the consistency of a fund’s performance over time—including the ups and downs of market cycles, which are an important test of a manager’s skill.
Rolling returns provide a particularly useful analytical tool for evaluating manager performance, especially during volatile periods when simply shifting the performance date range one or two months in either direction can paint a very different picture.
Equally important, these rolling returns reveal the size and breadth of the international small-cap market in a different dimension. That is, seeing the variance in performance patterns over time helps to show the significant opportunity set that exists in the large number of non-U.S. small-cap stocks.
Regions and countries do not move in lockstep; like sectors and industries, they have cycles with generally unpredictable movements that disciplined active managers seek to use to their long-term advantage.
Rolling Returns Reveal a Different Dimension of the Foreign Small/Mid Market
From 1/1/01 to 6/30/14
| Rolling Periods | |||
|---|---|---|---|
| One-Year | Three-Year | Five-Year | |
| Number of Rolling Periods | 151 | 127 | 103 |
| # of Periods Median Active Foreign Small/Mid Fund Outperforms MSCI EAFE Small Cap | 68 | 79 | 82 |
| % of Periods Median Active Foreign Small/Mid Fund Outperforms MSCI EAFE Small Cap | 45% | 62% | 80% |
| Average Annual Outperformance of Median Active Foreign Small/Mid Fund | 3.5 | 2.1 | 1.5 |
| Average Annual Outperformance of MSCI EAFE Small Cap | 3.5 | 3.2 | 2.7 |
We think this goes some way toward explaining why the median active foreign small and mid fund was able to outpace the MSCI EAFE Small Cap more frequently in the three- and five-year rolling periods than in one-year rolling periods.
Of course it is not easy to consistently outpace a benchmark, but we believe that highly disciplined approaches with a value orientation stand the best chance of outperforming broad non-U.S. small-cap indexes over long-term periods.
We think it is important for advisors to thoroughly understand the investment process of an active manager. This is especially true in the international small-cap space for the reasons outlined above.
Our belief is that approaches that have a long-term investment horizon, a value orientation, and a consistently applied discipline offer significant opportunities to add value—that is, to outperform.
