Quantitative managers are barreling their way into small-cap value stocks, historically the domain of traditional active money managers.
The hottest subasset class of the past two years, small-cap value stocks typically have been dominated by bottom-up stock pickers, who say they can ferret out these little-noticed companies that are underpriced and poised for a rebound. For the two years ended March 31, the Russell 2000 value index has returned an annualized 21.6%, in sharp contrast to -11.4% for the Standard & Poor's 500 index.
While some quant shops have invested in small-cap stocks for more than 10 years, major managers such as State Street Global Advisors, Boston, and American Express Asset Management Group's Kenwood Capital Management LLC, Minneapolis, are seeking to elbow their way into the institutional market.
Other quant managers, including LSV Asset Management, Chicago, and Aronson + Partners, Philadelphia, closed their small-cap products to new business more than a year ago. A bunch of these largely computer-driven investment processes are turning up at the top of their universes: LSV and Boston-based Martingale Asset Management ranked in the top decile of the Pensions & Investments Performance Evaluation Report's small-cap value universe in the first quarter of this year, returning 14.2% and 13.2%, respectively.
Performance hasn't always been so strong, as many quant approaches were hammered during the technology stock rally from 1998 until its peak on March 11, 2000. "We really were in the wilderness for a good, long time. We really looked like idiots," said Kevin Johnson, partner at Aronson + Partners.
But times have changed in favor of value managers. "You could buy low price-to-ZIP code at this point, and it would work," Mr. Johnson added.
"Typically, quant managers, relative to their benchmarks, have a deeper value orientation... So when you have an environment where value does better than growth, that's where the quants appear to do their best," explained Erik Ogard, U.S. equity small-cap portfolio manager at Frank Russell Co., Tacoma, Wash., which runs more than $4 billion in small-cap assets in multiple-manager strategies.
With many traditional approaches closed to new business, demand for new product - quant or not - remains strong. "The reason why we have quant value products coming to the market is because there is demand for small-cap value product, period," said Roger Fenningdorf, director of global manager research for Rocaton Investment Advisors LLC, Darien, Conn.
But quant managers insist they have an edge over traditional approaches.
One reason is that quant managers can look at far more stocks than a traditional manager can. "In the U.S., there are over 6,000 stocks. We would throw out the top 500 stocks (by capitalization). The fact that you can have an opinion on 5,500 companies (provides) many to choose from to find value," explained Bill Ricks, chief investment officer of AXA Rosenberg Investment Management LLC, Orinda, Calif., which manages $4 billion in its small-cap core product.
Without having to make a single face-to-face meeting with executives of portfolio companies, AXA Rosenberg's model tears apart company balance sheets and income data. Unlike other quant models, which tend to be purely value-oriented, AXA Rosenberg's model also predicts near-term earnings, figuring out how much each company will earn and comparing earnings to the stock price. While the model is value-oriented, 40% of returns are attributable to growth factors.
The ability to analyze a large number of stocks also allows quant managers to keep a much larger number of holdings in their portfolios. More holdings not only provide greater diversification, but also make it possible for quant managers to run greater sums of money in small-cap portfolios, which typically are limited by trading constraints.
At one end of the scale, Barclays Global Investors, San Francisco, runs around 600 to 800 stocks its in small-cap value portfolios, while LSV typically owns about 110 to 120. Even at the lower end, that's more than double the number of stocks held by a traditional small-cap manager.
Plus, quant managers point out that they take very limited bets against their benchmarks, providing risk controls increasingly sought by pension executives even in the small-cap arena. Aronson takes no bets against the 13 sectors it uses, while industry bets are very modest - on the order of 200 to 300 basis points, Mr. Johnson said. BGI keeps its sector bets to between 1% and 2% of the benchmark, said Rhonda Vitanye, investment strategist.
As a result, tracking error relative to the benchmark tends to be very low, and information ratios are high. Josef Lakonishok, principal and chief executive officer of LSV, said the firm's historical tracking error has been about 600 hundred basis points - driven up because of the tech-stock boom. Going forward, tracking error should be kept to 450 basis points, he said.
And, with any model, different factors can be added over time. Martingale started looking at earnings quality and management quality in the third quarter of 2001, before the current wave of second-guessing management practices got under way. And SSgA started poking into the quality of company balance sheets more than a year ago, "well before Enron and Tyco," said Mike Caplan, portfolio manager.
Small-cap quant strategies are proving to be a terrific way to grow a business. Martingale, for example, pulled in $100 million in small-cap assets last year, the first year it marketed the product. "We saw it's going to be a huge growth area," said William Jacques, the manager's chief investment officer.
Others are piling on. Kent Kelley, principal and senior portfolio manager at Kenwood, said "insatiable demand" for small-cap products is helping his firm to get started, even though its track record dates only to Jan. 1, 2000 - less than the three-year minimum record required by many pension funds. With a small base of $5 million in small-cap value assets under management, Mr. Kelley hopes to have $10 million to $20 million by June 30. The firm also subadvises on some $700 million in small-cap core assets for parent American Express.
Mr. Kelley left his job as chief executive officer of Travelers Investment Management Co., Hartford, Conn., to establish Kenwood, along with Jacob E. Hurwitz, a TIMCO senior vice president. He said the major innovation in its small-cap value strategy is the 12 sector models it has created. This approach enables Kenwood professionals to optimize the best mix of factors in its models.