Evaluating Small-Cap Active

Abstract

Conventional wisdom maintains that small-cap active equity funds have had higher excess returns than their larger-cap counterparts because the small-cap market is less efficient and provides greater stock-selection opportunities. This article reexamines the widely touted historical out-performance of small-cap funds through formal returns-based style analysis under alternative benchmarks using a large survivorship-bias-free mutual fund database. The authors find that small-cap alpha is not robust across equity style benchmarks, is concentrated among small-cap growth funds in the years surrounding the U.S. equity market bubble, and is strongly associated with a “buy-past-winners” momentum factor that primarily reflects a Russell reconstitution effect. Under MSCI benchmarks, the relative performance of the median small-cap fund manager is zero before costs, and is economically and statistically negative after costs. Finally, the authors show that the historical probability of an active small-cap fund achieving positive alpha is equivalent to a coin toss before costs, even if the fund outperformed in the previous year. This lack of persistence demonstrates that indexing is a powerful strategy among small-cap stocks. <b>TOPICS:</b>Mutual funds/passive investing/indexing, performance measurement, factors, risk premia