Conditional performance, portfolio rebalancing, and momentum of small-cap mutual funds

Abstract

To assess the performance of small-cap stocks net of transaction costs, we analyze 165 actively managed small-cap oriented portfolios. Our analysis addresses three areas of interest: (i) performance net of transaction costs, (ii) the magnitude of trading costs incurred when rebalancing an actively managed portfolio, and (iii) the potential for momentum strategy profits when investing in small-cap stocks. Using conditional estimation, we find that small-cap funds have earned a significantly positive abnormal return of about 2% per year in the period January 1986 to December 2000. We also estimate the cost of January rebalancing to be 0.4% of portfolio value, a value that is significant for over 20% of the portfolios under study. Finally, after trading frictions are taken into account, we find evidence that small-cap portfolios exhibit significant return patterns, similar in nature to momentum patterns initially documented in a frictionless setting by [J. Finance 48 (1993) 65; J. Finance 56 (2001) 699]. Our findings support recent behavioral models, which attempt to explain these patterns. Consistent with the findings of Jegadeesh and Titman, we find that past “winners” continue to outperform in the next 12 months, followed by a performance reversal.