Do International Actively Managed Small-Cap Funds Add Value?
April 12, 2016
by Larry Swedroe
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One frequently hears active managers claim that they avoid the large-cap U.S. market because it’s too hard to find undervalued stocks. By that reasoning, actively managed small-cap international funds should be alpha-generating powerhouses. Let’s see if that’s true.
Previously, I’ve examined the ability of domestic, actively managed small-cap funds to add value. My analysis showed that if you had a perfectly clear crystal ball and could identify which funds would be the largest actively managed funds at the end of a 15-year period, it’s likely that you would have outperformed passive strategies.
However, I also showed that, even with such foresight, these top-performing funds were unable to generate sufficient alpha to overcome their expense ratios and other costs. On average, the 10 largest funds produced a slightly negative alpha — though the negative alpha was smaller than their expense ratios.
I’ll now turn my microscope on international, actively managed small-cap funds, an asset class that active managers claim is even more inefficient than domestic small-caps. As I did with my analysis of domestic actively managed small-cap funds, to keep the list to a manageable number of funds, I have selected to analyze the performance of the 10 international developed small-cap funds with the largest amount of assets under management (AUM) as of the end of 2015.
To ensure that I examine long-term results through full economic cycles, as I did with the domestic small-cap fund analysis, I’ll analyze fund performance over the 15-year period ending December 31, 2015. When there is more than one share class of fund available, I will use the lowest-cost shares obtainable for the entire period. Later, I will expand my evaluation to include the entire universe of funds that survived the period under review.
As I observed in my article on the domestic small-cap funds, this methodology creates a substantial bias in the data. I am considering only funds that survived the full period, and a significant amount of all mutual funds disappear each year. Second, the AUM of a fund that has outperformed its benchmark will benefit not only from that strong performance, but it will also benefit from the investor cash flows that tend to follow.
Thus, the funds with the strongest past returns will tend to be the largest. This doesn’t mean that investors actually earned the same returns over the full period since they may not have been invested over the full term. Therefore, the results are not truly reflective of what investors in these actively managed funds actually secured — they are biased upward.
We should expect the funds with the most AUM to have outperformed, although the research shows that their large asset size is likely to hinder future performance. The larger questions I will answer are the following: First, if you were smart (or lucky) enough to identify these 10 stellar performers ahead of time, by how much did you benefit compared to using passive alternatives? Second, was it worth the risk that you might have been wrong in your choice?
With the aforementioned bias in mind, the table below shows the performance data for the 10 largest actively managed small-cap funds as of year-end 2015. My standard practice is to compare the returns of these funds to the returns of comparable funds (based on Morningstar’s categorization) from the leading provider of index funds, Vanguard and the structured portfolios from Dimensional Fund Advisors (DFA), a leading provider of passively managed asset class funds. (In the interest of full disclosure, my firm, Buckingham, recommends DFA funds in the construction of client portfolios.)
DFA funds can be purchased through some 529 and 401(k) plans, but generally they are available only through an advisor. An investor would incur fees from that advisor; those fees vary greatly (in some cases they are very low) and cover the full range of financial planning services provided by the advisor. Also, John Hancock recently introduced a series of ETFs that are managed by DFA (with expense ratios that differ from the DFA funds cited in this article). Those ETFs can be purchased directly by investors. All Vanguard funds can be purchased directly by investors.
Unfortunately, Vanguard doesn’t have any index funds that meet my requirements. As a result, while my preference is to use live funds as benchmarks (so we can see realizable returns, after implementation costs), I’ve used the MSCI World ex-U.S. Indexes as benchmarks in place of the Vanguard funds. In addition, for international funds, Morningstar combines small-cap and mid-cap funds into one category. Thus, the comparisons may not be as “apples-to-apples” as the domestic comparisons.