The Perfect Storm For Risk-Conscious Active Managers by The Royce Funds
Principal and Portfolio Manager Steve Lipper discusses three specific conditions that have shaped the current small-cap market and how, after five years, these developments all showed signs of reversing in the latter part of 2014.
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Francis Gannon: You recently completed a research paper on the current small-cap market cycle. What did you find?
Steve Lipper: We took a look at the last five years and we found three things of note: low and declining costs of capital, low volatility, and—perhaps surprisingly—also high returns. So let’s take those one at a time.
So cost of capital is a good metric. A proxy for that is the yield spread on high-yield bonds versus treasuries. That lets you know how easy it is for a company—perhaps a company with more debt—to access capital. Well, you go back to the spring of 2009 and that yield spread was 18 percentage points. You roll forward to the end of last year and it was only 5%. That enormous decline had a very favorable effect on companies with a lot of debt. The world behaved almost upside-down. The way capitalism normally works is there’s a penalty for having a lot of leverage, but during this period it was really a benefit to as much leverage as possible.
The second thing we found—and I think this might strike most investors as surprising—was how low volatility was compared to history. If we took a review of the headlines and we remind ourselves about the perpetual European crises, government shutdown, or fiscal cliff, or various QEs, I think an investor would say, “Well, it’s probably been a pretty volatile period.” It’s actually been below average in terms of volatility when you compare over the past number of decades.
Then perhaps even more surprising, what’s been coincident with that has been higher than average returns. Over the five-year period, small-cap returns have compounded over 15% a year. Now if we go back all the way to the history—35 years ago—of when the small-cap index started and we look at rolling five-year periods, that’s in the top quartile of returns that we’ve ever had, and, again, probably a bit surprising to investors is that you have returns that good—way above-average returns in a period with low volatility.
Francis: I guess the obvious question here is: Are any of those factors showing signs of reversing?
Steve: Actually, all three are, in different stages. The cost of capital, or yield spread, or what it takes for a more indebted company to access more capital: that very clearly is beginning to reverse. We saw in 2014 the yield spread on high-yield bonds go up about 100 basis points. So that’s going to create more differentiation across companies with different balance sheets.
The interesting thing about volatility is it’s not clear why it has been so compressed. One theory—which seems to hold some credence—is in the U.S. the amount of liquidity that was injected by the Federal Reserve acted as a shock absorber. In terms of returns, our outlook is it is unlikely to see the sort of mid-teens return for small-caps going forward.
Francis: What kind of effect did these factors have on The Royce Funds’ performance?
Steve: From an absolute return perspective, many of our strategies delivered higher than their long-term historic returns but they also delivered below the benchmark, so weaker relative returns. And there are very clear reasons for that.
If you’re a risk-aware manager that tends to exclude companies with a high amount of debt, those companies have been the greatest beneficiaries of this decline in the cost of capital. So that has benefited the benchmark, but not our portfolios. When the cost of capital rises, the differentiation on quality of balance sheets tends to play more to our favor.
What we’re doing as active managers is trying to isolate those situations where there’s a difference between a company’s true worth—in our view—and the stock price. When the stock price is more volatile we’re going to have more opportunity to do that.
So lower volatility, we’ve looked historically, has been periods where we have not done as well. Higher volatility, we’ve done better.
The third, in terms of absolute returns, has been the most striking. When there have been returns of 15% annualized or above, those have been among our weakest in terms of relative performance.
Francis: This has been a pretty challenging period from a performance standpoint for many of the Royce Funds. What has historically happened after these periods of underperformance?
Steve: So we looked at Pennsylvania Mutual Fund and we looked at the entire history of the Russell 2000 Index, looking at rolling five-year periods, and we said, “How often has Pennsylvania Mutual Fund underperformed by 300 basis points or more, and then what happened after that?” We found about 30 periods where it underperformed by that amount.
In the subsequent five-year period, 92% of the time Pennsylvania Mutual Fund outperformed, and even though it underperformed by 300 basis points or more in that period, the outperformance was over 600 basis points on average. So we’re hopeful that we’ll have that kind of reversal again.