article , video 09-28-2016

What Is The Connection Between Value-Led Small-Cap Markets and Success for Active Management?

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. 


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.

Actively Managed Small-Cap Portfolios Outperformed in Value Led Markets
5-Year Monthly Rolling Returns from 12/31/78 through 6/30/16 (391 Periods), and & of the Periods Morningstar's Small Blend Category1 Average Beat the Russell 2000

Actively Managed Small-Cap Portfolios Outperformed in Value Led Markets

1There were 559 US Small Blend Funds tracked by Morningstar with at least five years of performance history as of 6/30/16. 
Source: Morningstar

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?

Active Spread of Small Blend vs. the Russell 2000
Five Years Ending 12/31/15

Active Spread of Small Blend vs. the Russell 2000

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.

Important Disclosure Information

Mr. Lipper's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that past performance trends as outlined in this article will continue in the future.

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. The performance data and trends outlined in this presentation are presented for illustrative purposed only. Historical market trends are not necessarily indicative of future market movements. The Royce Funds invest primarily in securities of micro-cap, small-cap, and/or mid-cap companies, which may involve considerably more risk than investments in securities of larger-cap companies (see “Primary Risks for Fund Investors” in the respective prospectus). The Funds may also invest to varying degrees in foreign securities which may involve political, economic, currency, and other risks not encountered in U.S. investments.

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 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

For the Morningstar Small Blend Category: © 2016 Morningstar. All Rights Reserved. The information regarding the category in this piece is: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

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