The Undiscovered Connection: Value-Led Periods And Active Management by Steve Lipper
We recently completed research into small-cap performance patterns that revealed a connection that we believe is significant. There seems to be a notable historical trend of active small-cap managers outperforming the Russell 2000 Index in periods when value stocks lead, while trailing the small-cap index when growth stocks lead.
What’s Happening to Active Small-Cap Management?
Contrary to some investors’ perception, active small-cap managers actually have a strong relative performance record. Comparing Morningstar’s Small Blend category average (our proxy for active small-cap management) to the Russell 2000 Index over rolling five-year periods reveals that the Small Blend average beat the index 66% of the time.
What accounts, then, for the recent poor results of the active small cap managers? We recently completed research into small-cap performance patterns that revealed a connection that we believe is significant. There seems to be a notable historical trend of active small-cap managers outperforming the Russell 2000 Index in periods when value stocks lead, while trailing the small-cap index when growth stocks lead. If this pattern holds, it carries a number of important implications for the current market, particularly if we are beginning an extended period of outperformance for value.
Small Blend Funds Often Succeed When Value Leads
Our research first compared monthly rolling five-year returns for the “as published” Morningstar Small Blend category average to the Russell 2000, dating back to the index’s inception in 1979. We then separated each rolling five-year period into those in which the Russell 2000 Value Index led the small-cap market, and those in which the Russell 2000 Growth Index led.
The results were striking. Though the Morningstar Small Blend category average beat the Russell 2000 in 66% of all rolling five-year periods, it actually outperformed in 83% of value-led periods, but in only 21% of growth-led periods. And most periods—73%—were value-led, which contributed to greater relative success for active management.
Scrutinizing Our Findings
These results were so compelling that we challenged them with four questions:
- Is the Small Blend category an appropriate proxy for active small-cap management?
There are a number of limitations to using the Small Blend average. First, it only covers mutual funds, a subset of all active managers; second, Small Value and Small Growth managers are also active managers; and third, while Small Blend funds may be intentional about their style positioning, it may also be a residual of where their managers see current opportunities. We chose to use Small Blend as an active management proxy primarily because it is relatively style neutral and therefore a more appropriate comparison to the Russell 2000. Moreover, we feel confident that most observers would expect Small Value managers to do better versus the Russell 2000 in value-led periods. This beneficial relationship for Small Blend managers, however, was more unexpected.
- How could this data show such strong results when so few active small-cap funds are currently outperforming the index?
The idea that only a few funds are outperforming the index is somewhat mistaken since 53% of Small Blend (main class only) funds (101 out of 192 funds) beat the index on a trailing five-year basis ended 6/30/16.
- Has this advantage been due to survivorship bias or funds moving from ‘Value’ to ‘Blend’?
No. According to Morningstar, the Small Blend category average is in effect a frozen snapshot. We calculated trailing five-year returns from historical monthly category average return data which reflects all funds in existence that were classified as Small Blend in that month.
- Has this relative performance connection been consistent over time?
The active spread of Small Blend versus the Russell 2000 for the trailing five years seems to have roughly tracked periods of value and growth leadership through history. This chart shows the active spread in green tracked along the spread between Russell 2000 Value and the Russell 2000 in gray. Periods of leadership for growth are shaded—they were relatively rare until the most recent seven-year period (2008-2015).
What explains this connection?
We wanted to know why value-led periods are far more conducive to active outperformance than growth-led periods. Our view is that two distinct factors affect this outcome: equal weighted portfolios vs. cap weighted indexes and active managers’ training.
Equal Weighted Portfolios vs. Cap Weighted Indexes
First, most actively managed portfolios weight their holdings closer to equal weighted than based on capitalization. This means that active managers are likely to be challenged when trying to keep pace with their respective indexes in periods with narrow leadership—those dominated by a comparatively smaller number of stocks at the upper range of the index constituents.
Growth-led markets tend to demonstrate narrow leadership more often than value-led markets, which typically feature broader participation. 2015’s results offer an instructive example of this performance profile of a growth-led market with narrow leadership. The market-weighted Russell 2000 declined 4.4% in 2015, but fell 10.1% on an equal-weighted basis. During the same year, the Morningstar Small Blend category trailed the Russell 2000, falling 5.3%.
Extending back in time, the relationships among value and growth, equal-weighted and market cap-weighted, and active and passive become even clearer. For the five years ended 12/31/15, small-cap growth led value (+10.7% vs. +7.7%), the Russell 2000 led the equal-weighted index (+9.2% vs. +6.5%), and the unmanaged (that is, passive) small-cap index led active managers (+9.2% vs.+ 8.3%). Unsurprisingly, over this same period only 45% of Small Blend (main class only) funds (85 out of 189) beat the Russell 2000.
From these observations, we would venture that value-led markets are characterized by a larger number of stocks advancing—and that this positive breadth helps create an advantage for active management.
Active Managers’ Training
The classic training for portfolio managers and analysts contains a heavy dose of valuation work. Successful active management can be distilled to identifying situations where the intrinsic value of a company is appreciably higher than its current stock price, and this may be a second factor in Small Blend’s advantage in value-led markets. The ability to effectively use various valuation metrics is integral to this practice. As a result, active Small Blend managers will lean towards stocks with valuations selling for less than their intrinsic value and quite often less than their relevant benchmark.
Seen this way, most active Small Blend managers could be described, to some extent, as value managers. Their respective investment disciplines will make them hesitant to own, and certainly reluctant to hold at the top end of their portfolios, stocks whose valuations are meaningfully higher