Adapting "The Emperor's New Clothes" to money management, prominent investment consultant Richard M. Ennis says the notion that small-cap and midcap managers generate consistent superior investment performance is a myth.
Mr. Ennis, who late last year wrote an article saying equity managers should be given broad leeway in investing their portfolios and not be tied to narrow mandates, is mounting his latest challenge to standard notions of equity portfolio structure.
The implications for money management are substantial. As Mr. Ennis noted in an article he co-wrote with Michael D. Sebastian, director of analytical development at Ennis Knupp & Associates, Chicago, that will appear in the Journal of Portfolio Management early next year, it makes as much sense to invest passively in small-cap and midcap stocks as large-cap stocks.
Another implication is that pension executives could use a single stock index fund, such as one tied to the Wilshire 5000 or the Russell 3000 index, that would match a fund's overall benchmark for the asset class, instead of breaking equities into smaller subcategories. A third inference is that a fund could adopt a "whole-stock portfolio" advocated by Mr. Ennis late last year, which gives managers investment freedom across a wide range of stock capitalizations and styles.
No `fish in a barrel'
"We're not making the case that you shouldn't be active in this asset class, but we are taking exception to the notion that it's like shooting fish in a barrel," Mr. Ennis, a principal at Ennis Knupp, said in an interview.
The article drew varied responses from experts. "It's well-done and well-written, and kind of unassailable," said Kevin Johnson, a partner with Aronson + Partners, Philadelphia, which manages some $5 billion in various quantitative value strategies.
Ron Kahn, managing director and head of active equities at Barclays Global Investors, San Francisco, said: "There's certainly been a myth. The myth was that it was easy to outperform in small cap. What Richard has shown is that, at least on average, it wasn't easy to outperform."
However, Mr. Kahn added, "small-cap is actually a good place to build strategies" for skillful managers, noting that BGI's active small-cap strategy has generated excess returns of four percentage points a year for the past 11 years.
Conclusions opposed
Paul Greenwood, senior research analyst at Frank Russell Co., Tacoma, Wash., demurred. "Our analysis and experience doesn't support the conclusions they reached. "All of our work leads us to believe the small-cap segment of the market is the most inefficient segment of the market."
Many pension executives and consultants believe the market for large-cap stocks is very efficiently priced, and there is relatively little value that money managers can add by actively managing such portfolios. In recent years, pension executives have directed a massive shift toward indexing or semi-indexing such portfolios, while seeking to gain alpha - or added value - from actively managed small-cap and midcap portfolios.
Pension funds have pumped billions of dollars into active small-cap and mid-cap strategies. Universes of investment products show that small-cap managers outperform their benchmarks by substantial margins over varying periods of time.
Now, Messrs. Ennis and Sebastian aim to prove that alpha stems from a combination of three errors: overlooking fees; using an inappropriate benchmark; and ignoring survivorship effects and other biases.
Constructing a sample of 128 active small-cap products from the Mobius Group M-Search database, the researchers found that the median portfolio outperformed the Russell 2000 index of small-cap stocks by an average 4.04 percentage points per year over the 10 years ended June 30, 2001.
But the vast majority of those returns were calculated before fees were subtracted. Netting out manager fees reduced the median alpha to 3.09 percentage points, still a healthy return.
No single index
A bigger issue is that the authors say use of a single index to benchmark returns is inappropriate, given the great degree of heterogeneity among small-cap portfolios. Instead, based on Nobel Laureate William F. Sharpe's 1992 work on style analysis, they developed for each portfolio an "effective style mix" that combines several indexes based on each portfolio's characteristics. The upshot: The median small-cap portfolio (net of fees) outperformed its new bogey by an average of 1.2 percentage points a year.
A third issue is the effect of survivorship bias and retroactive inclusion of historical data from managers joining a given performance universe.
The latter issue of "backfilling" is "the most insidious thing," Mr. Ennis said in the interview. Studies show how the median return has crept up for the same period of time. For example, in one universe, the median return for small-cap growth portfolios rose to 12.6% from 10.4% over a five-year period, according to Pensions & Investments' Performance Evaluation Review.
Messrs. Ennis and Sebastian believe that survivorship bias may be greater for small-cap than large-cap portfolios. Net return inflation of two percentage points a year in databases reduces that original four percentage-point outperformance to zero or negative, they concluded.
Rather than being easier to make money in small stocks, it might actually be tougher, they wrote. Another study the authors cited found that, in a survivorship bias-free universe of nearly 4,700 funds, large-cap portfolios achieved higher average alphas than small-cap ones from 1962 to 1998.
Smaller-cap fees
Why? The answer may lie in the higher fees and transaction costs charged for smaller-cap portfolios. The authors estimated typical management and trading costs for small-cap portfolios at more than 200 basis points a year, vs. 90 for large caps.
"Whatever the differential in market inefficiency between large and small might be, it is not sufficient to justify the greater cost of researching and actively trading smaller stocks by the average manager," they wrote.
"In every period, some active small-cap portfolio managers achieve superior results, and we do not deny the existence of (managers) with sufficient skill to add value with reasonable consistency. We find no general evidence, however, that superior performance persists from one period to the next among small-cap managers."
Russell's Mr. Greenwood disputed Mr. Ennis' contention. He said the Russell universe of small-cap managers, measured by the real-time mean, which eliminates survivorship and other biases, shows the average manager produced an annualized alpha of about 350 basis points for the 10-year period ended June 30. Subtracting 100 basis points for management fees, that still leaves 250 basis points of outperformance, he noted.
