What Is The Connection Between Value-Led Small-Cap Markets And Success For Active Management? by Steve Lipper,
Senior Investment Strategist Steve Lipper takes a close look at the connection between value-led small-cap markets, success for active management, and what might explain the connection.
Watch the video here.
The first London Value Investor Conference was held in April 2012 and it has since grown to become the largest gathering of Value Investors in Europe, bringing together some of the best investors every year. At this year’s conference, held on May 19th, Simon Brewer, the former CIO of Morgan Stanley and Senior Adviser to Read More
Is There a Connection Between Value-Led Markets and Active Management?
We have done some research recently that combines two areas that people have looked at separately but never looked at a correlation, and we found something interesting.
The first thing is, it is generally acknowledged that there are cycles between growth and value stocks. It is also generally acknowledged that there are cycles of active managers outperforming and passive indexes outperforming.
What we looked at in the small-cap space was–was there a relationship between the two and there seems to be.
Here is what we did. We took a look at the five-year returns, every five-year return back to the inception of the small-cap indexes, and we labelled them as either a growth-led market, or a value-led market, and then we took a look at the small-cap blend average manager versus the benchmark and we said who outperformed? Did passive outperform? Or did the average manager outperform? We found something striking.
In value-led markets over 80% of the time small blend outperformed. We think that this is even more notable for three reasons.
First, recall that those returns are active managers after expenses and the benchmark without expenses. The second thing that is striking about that is this survivorship-bias-free, so we took the as-published numbers, not just those funds that survived over time. And the third is, this is just the results for the average manager, half of the category did even better than that.
What explains the connection?
We think there are two factors that are really driving this. The first is that in our observation growth-led markets tend to be more narrowly led. Why does that impact? Well, benchmarks are market cap weighted, so a few stocks doing well can really lift them. Most active managers’ portfolios are closer to equal weighted, so how does that play in?
Well, let’s take an example of 1999, probably the prototypical growth-led market and narrow market. The benchmark, the Russell 2000 was up over 59% in that calendar year but the average small blend manager was up only 19%. That is part of the relationship, is that we think that growth tends to be narrow and narrow tends to favor the benchmark.
The second thing is that nearly all of us that are fundamental managers were trained in valuation tools during the time that we learned about active investment management. Those valuation tools make us hesitant to buy stocks or have those stocks heavily weighted in our portfolios that have very high valuations. However, those are exactly the stocks that lead in growth-led markets, so we think it is really those two factors.
What are the implications for asset allocators?
We think there are meaningful consequences on this for asset allocators and it drives again, to how much we think the next five years may look very different than the last five years.
There has been separate commentary about the last five years being growth-led and also why passives have done really well. Well, if we’re right and we have said elsewhere that we really expect a shift in leadership from growth to value and the historical relationship holds, this may be an active-led market as well.