Conventional wisdom holds that money management firms lose their performance edge as they grow. In order to assess whether this popular conception is true, we analyzed the returns of 515 mid- to large-cap U.S. equity managers. During the five-year period ended Sept. 30, 1993, we found:
More than 71% of the managers in the top performance quartile are with firms managing less than $2.3 billion each. This result implies that the firm size requirements typical of large plan sponsor searches immediately exclude most of the best managers.
The performance composite of the smallest management firms delivered its best results in down markets.
Another common perception is that smaller management firms outperform in part because they have greater freedom to invest in smaller-cap stocks. As demonstrated below, this notion, even if true, does not drive our results. Similarly, periods of relative strength for small firms correspond equally well to periods of strength for either value or growth strategies.
Offsetting these advantages, managers in smaller firms tend to cluster in the fourth performance quartile as often as in the first. Investors seeking to realize the performance potential of small management firms should therefore employ a systematic approach that includes both qualitative and quantitative manager evaluation. Those lacking strong confidence in their ability to select the best managers might prefer to constrain themselves to larger, more uniform firms. Skillful investors, however, will find their abilities best rewarded by broadening manager searches to include smaller firms.
Giants and Lilliputians
The study sample consists of 515 U.S. equity products offered by 406 firms drawn from the Nelson's Institutional MarketPlace database. We excluded index and hedge funds, considering them inappropriate to the study. We also omitted all managers who reported a small-cap or small/midcap orientation in order to help demonstrate that small firms do not gain their performance advantage solely from small-cap stocks. The five-year period studied includes a full business cycle and periods of strong and weak performance for all major investment styles.
We categorized equity managers according to the total assets managed by their firms in 1988, including both equity and fixed income. Sorting firms by asset size, we set breakpoints at 75%, 90%, 95%, and 99% of all the assets managed by all firms in the sample. We chose these breakpoints arbitrarily to highlight the heavy concentration of assets in the industry's largest firms. Table 1 shows that the top 91 managers, representing just 17.7% of the sample, are with firms controlling 75% of all the $1.36 trillion in assets held by the sample. In contrast, the smallest 54.9% of all managers in the sample are with firms that controlled just 5% of all assets.
Note in Table 1 the constraints that this extreme concentration places on large investors. Suppose, for example, that a large institutional investor sets its minimum allocation at $250 million per management firm. If policy prevents the investor from representing more than 10% of any single firm's business, then that investor is constrained to size classes 1 and 2, or just 34.6% of all the managers in our test sample.
David 1, Goliath 0
Constraining manager searches to the multibillion dollar firms in classes 1 and 2 automatically eliminates 71.5% of the managers in the top performance quartile. In Table 2, the smallest management firms (size class 5) alone make up 40.6% of the top performance quartile, even though they are only 33% of the total sample. No other group is over-represented in this way. Our results therefore suggest that while selecting a smaller management firm cannot guarantee higher performance, clients searching for superior performance potential are most likely to find it in this category.
In Table 2, note that class 5 managers make up more than their share of the bottom quartile as well as the top quartile. The bulk of managers in size classes 1 and 2, in contrast, fall into the middle two quartiles. This pattern is a function of the greater dispersion of the smaller management firms' results. Table 3 shows that small management firms cover a broader performance range on both the upside and downside even though they look similar to other groups at the median. These results suggest that as money management firms grow, the distribution of their performance tends to converge toward the median.
Institutional investors can use the information in Table 3 to adjust the breadth of their manager searches. The data suggest that institutional investors with a record of picking management firms with median performance should constrain themselves to the more uniform managers in class 1, since this group has the highest median. A top quartile (i.e., 25th percentile) performer in class 1, however, would only have ranked at the 30th percentile within the entire test universe, and at the 35th percentile among the smallest management firms. Institutional investors skilled at manager selection can, therefore, improve their results by broadening searches to include smaller management firms.
Strength in numbers
To get some idea of how management firms of different sizes work in multimanager investment programs, Table 4 shows equally weighted composites of quarter-by-quarter performance for each size class. Consistent with our experience, the smallest management firms outperformed the average of all other groups by 45 basis points per year.
Despite their more varied returns, groups of small management firms can even have superior defensive characteristics. Table 5 below breaks the evaluation period into up and down markets quarter by quarter, and examines how each group of managers behaved in those different market environments. Out of sixteen quarters in which the market rose, the smallest management firms as a group outperformed the S&P 500 nine times by an average of 1.23%, and underperformed seven times by an average of 1.28%. This record is not appreciably different from that of other groups.
However, during the four bear market quarters, which notably include the October 1989 minicrash and the Gulf War, small management firms outperformed in every case. These results are again consistent with experience. Small management firms taken individually have less predictable performance but, when taken in groups as in a multi-manager program, they appear to reduce the risk of relative underperformance during critical periods.
Nothing up our sleeves
Another common perception is that the small-cap effect works to the advantage of smaller money management firms, since lower liquidity constrains large funds from investing heavily in higher-performing small stocks. To examine whether this notion is correct, we excluded all dedicated small and small- to midcap managers from the test sample. We estimate the bull market for small-cap stocks (as well as midcaps) started in the last quarter of 1990 and continued through the third quarter 1993. During this period on an annualized basis, the S&P 500 gained 9.73% while the Russell 2000 lost 5.93%. In contrast, from fourth quarter 1990 to third quarter 1993, the Russell 2000 gained 28.14% per annum while the S&P 500 gained 18.07%.
Table 6 shows that class 5 managers outperformed class 1 managers in the two years when small and mid-cap stocks underperformed. Class 5 then performed much less strongly over the three years when small caps did well. This is exactly the opposite of the pattern one would expect if the general outperformance of class 5 managers were due to small-cap holdings.
Similarly, the test period was evenly divided between quarters favoring value and growth investment styles, as measured by the relative performance of the S&P/BARRA Value and Growth indexes. In value-dominant periods, class 5 managers outperformed class 1 managers at the median four times out of 10, and in the growth dominant periods six times out of 10. The record of small management firms thus does not appear strongly oriented toward either investment style.
The bottom line
Small management firms demonstrate both higher performance and the flexibility required to outperform in bear markets. These characteristics do not depend on the use of small or mid-cap stocks, nor on any particular investment style. The results of this study, however, do not support the use of small management firms unequivocally. Realizing the potential of smaller management firms still requires a comprehensive approach to performance analysis and qualitative evaluation.
Ted Krum is senior research analyst, RCB Trust Co., Stamford, Conn.