Chuck Royce – ‘The Long-Term Value of Active Management in the Small-Cap Space’

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As the ongoing debate about the effectiveness of active management, especially since the proliferation of ETFs and index funds, continues unresolved, it is difficult for us not to be biased. Our focus, however, remains solely on long-term outperformance and the interests of our shareholders, and we believe the best way of accomplishing this is through careful stock selection and having an absolute standard.

The long-running, and probably unresolvable, debate about active versus passive investment strategies has taken on new life in the years since the onset of the Financial Crisis, often to the detriment of active approaches.

To take one example, Morningstar compiled data showing that inflows into equity mutual funds have been dwarfed by those into equity ETFs (exchange traded funds) measuring from the momentous year of 2008. For the six calendar years from 2008-2013, traditional equity funds have taken in $5.52 billion while ETFs have attracted $389.08 billion. That’s quite a disparity.

It seems to be no secret that many active managers have struggled to keep pace with their respective equity indexes in these often eventful years. These years have also seen a raft of studies purporting to show that most investment managers are unable to consistently beat the market, i.e., regularly outperform a relevant index such as the Russell 2000 or S&P 500 Indexes.

Perhaps unsurprisingly, we would offer two caveats before one embraces uncritically the notion that passive investing is always better: First, a number of managers have consistently outperformed the market over long-term periods and especially within the small-cap asset category. In fact, we believe strongly in the idea that it is not necessary for all managers to beat the market in order for active management to be validated as an approach.

Our second note of caution relates to time periods. While it would be nice to outperform an index every year, it is just as unrealistic to expect that as it would be to expect an index to outperform active management every year. It is also unrealistic to expect a high degree of outperformance in the long term without experiencing some short-term underperformance periods.

A willingness to stick to one’s approach, regardless of market movements and trends, is critical to long-term outperformance in our opinion. This is especially important during market extremes because there are active managers who exhibit style drift or other changes in their discipline when their investment style falls out of favor or is stressed, such as during the tech bubble.

Successful active management also entails a willingness to think independently in terms of sector and industry weightings. It is not unusual for the most successful managers to be significantly out of sync relative to a benchmark index with respect to industry and sector weightings (commonly referred to as tracking error).

In addition, active managers are not required to invest cash inflows at the time of receipt when market conditions or prices may not be conducive. They may screen for quality and use buy/sell triggers as a means of reducing risk. While a passive manager must own everything, an active manager has the freedom to look for attractive stocks across a targeted universe.

All of this helps to explain why we remain so fond of small-caps and so confident in the effectiveness and value of active approaches in the asset class.

Active small-cap managers can capture valuation opportunities beyond their respective indexes—an opportunity that would be lost if one were limited to owning only the constituents that make up an index. For example, the Russell 2000, while quite broad, only includes about 2,000 of the more than 4,100 companies1 that make up the domestic small-cap universe (those with market caps up to $2.5 billion).

While self-serving, we nevertheless think that the small-cap asset class is ideally suited for active management given its enormous size, lack of institutional focus, and limited research availability.

Important Disclosure Information

The thoughts and opinions expressed in the piece are solely those of Royce & Associates, LLC, investment adviser to The Royce Funds. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of small-cap stocks may involve considerably more risk than investments in securities of larger-cap companies. (Please see “Primary Risks for Fund Investors” in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor’s based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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