The median performance of active fund managers with a small-cap mandate is uniformly better than the performance of their colleagues with a large cap mandate against their respective benchmarks.
Fewer than 40% of large-cap managers outperform U.S. large-cap equity. More than 60% of their small-cap counterparts do so. The pattern holds in other regions of the world as well, as for example where the benchmark is EAFE (Europe, Australasia, and the Far East) large- or small-cap equity.
This raises the question: where does the alpha come from? Using basic market theory as a premise, one expects that there must be some inefficiencies somewhere that generate this alpha and that are specific to the small cap world. What are they? That is the question asked in a paper newly released from Quantitative Management Associates (QMA).
Gavin Smith, vice president, portfolio manager and strategist for QMA’s US core equity investment team, wrote the report, which begins by distinguishing small-cap alpha from the more well-known phenomenon of small-cap beta. Yes, small-cap stocks are inherently riskier than large cap, and that does mean that small caps come with higher expected returns. That difference shows up in the benchmarks, though, and it doesn’t explain why small-cap managers do better against their benchmark than high-cap managers do against theirs.
Furthermore, Smith makes the point that small-cap beta isn’t all it’s cracked up to be. The original early-1980s studies on the subject were “based on data going back to the 1940s,” while “the more recent data reveals a more modest effect.”
That understood: how does the alpha arise?
One possible explanation that Smith considers is that the alpha may be beta in disguise. It may arise from the simple fact that managers in this space (including QMA itself) use factor-based models.
Smith doesn’t believe this to be an adequate explanation, although he concedes some truth to it: “Small-cap value managers will have some exposure to cheap distressed stocks, for example, and growth managers will have some exposure to high-flying momentum names.”
What else is going on, though? Smith contends there are a clutch of factors that allow misprices, which can be corrected by shocks such as earnings surprises. One of the factors here: a dearth of analyst attention. Large-cap stocks are covered by almost three times the number of analysts covering small caps. There are 291 stocks in the Russell 2000 that don’t have any sell-side coverage at all.
Smith writes that when “just a handful of analysts follow a company, even today it can take weeks or even months for reports and revisions to filter out into the investing public and get fully reflected in prices.” This allows for alpha for managers who get ahead of that process.
A related structural fact is the limited transparency of the small caps, even in the United States, “home of the world’s best-quality small-cap information.” In said U.S., large caps make earnings announcements, on average, six days earlier than small caps; and 30% forego earnings conference calls altogether.
The opacity creates uncertainty among both analysts and the investing public, meaning frequent mispricings, and opportunities for alpha.
Further, the phenomenon that behavioral economists call “anchoring bias” can be more powerful for the smaller caps. Anchoring is the all-too-human tendency to rely too heavily on a single trait or datum while assessing information. A common pedagogical example involves a buyer in the market for a used car, who might walk onto the lot telling himself that he has to make sure the odometer number is low. He may, in his over-reliance on the odometer, overlook something else, like the number of accidents reported or the care with which the transmission has been maintained. In stock picking, momentum can serve as an anchor, so that a random downturn in price can turn into a rout, with many investors heading for the exits, and only the wise alpha seekers picking up what are now bargains.
Such anchoring happens in the buying and selling of stocks at all levels of capitalization. But the cost and effort of accumulating information (and the relative ease of simply relying on price moves and betting they will continue) can magnify this effect in the small-cap space.