Jim Wiandt

Active vs. Passive Management for Small-Cap Funds

"Active management works better than passive index funds for small-cap and international funds."

This notion is so widespread that it has become conventional wisdom in financial circles. I have never seen much to back it up, and have largely held an agnostic view on the subject. In this study, we take a look at small-cap funds.

We attempted to address some of the issues that have dogged active/passive studies in the pass. First, we looked at investable returns, not index returns. We chose benchmark index funds to measure the performance of the field, and of course only included small-cap funds in our survey, eliminating the natural bias that exists when, for example, you compare the large-cap performance of the S&P 500 with a relatively small-skewed group of mutual funds.

How did it come out? Well, the active funds lost. Basically, if you'd chosen a small-cap index fund (there are very few), you'd have beaten the active field in almost any time period in the study. I must admit that the results surprised me to some degree. I was fully prepared for an active rout given the tremendous advantage we hear that active funds have in researching small companies. I was even ready to publish the results - we just want to tell it like it is.

Here's the way it is:

• Over the eight 3, 5, 10, and 15 year periods covered by the study, a majority of active funds lost to their index fund counterparts on seven occasions.
• Over the past ten years, passive index funds have outperformed their active opposites eight years (with one tie).

In the year-end study we did surveying the mutual fund industry, I at least compiled enough evidence to be convinced that there was a lot of apples vs. oranges comparison going on. Active vs. passive analysis, across all equity sectors, tends to change over different time periods, based more on sector performance than actual fund performance.

Even the seminal charts put together by John Bogle in his books suffer from this problem. This can be clearly seen from the wild swings in numbers from year to year. Take a look at this chart that Saint Jack put in his latest book, for instance. It compares the returns of the S&P 500 to those of the field of equity funds:

In years when large has had a good run, most mutual funds get crushed by the S&P 500 (very much a large-cap) index. Look at the late 1990s. On the other hand, when other market segments (small-cap of course being one of these) are outperforming large U.S. stocks, the numbers dip to less than 50 percent losing to the S&P 500.

For a nominally more fair evaluation, see the chart comparing all funds to the Wilshire 5000. It's in Bogle's first book, Bogle on Mutual Funds. Because of the representation of the total market, it is a better approximation. And the more moderate numbers on both sides speak to this. Still, the fact that only around 15% of funds have beaten the total market over the 5-year, 10-year and 15-year periods through 2000 is clearly not a pretty site. Nonetheless, style preference and style drift of funds still make this a less-than-ideal comparison.

The other point of contention is that on average one expects the total return of funds to equal market minus costs. Even the vaunted Vanguard 500 fund does not beat its index on TOTAL return. With dividends figured in to index returns, over time the Vanguard fund lags the S&P 500 index by in the neighborhood of 10-20 basis points (0.10%-0.20%), though the Vanguard 500 has actually outperformed the index with creative fund management over the past three years. Minus taxes, returns fall off some more.

Here are the criteria we used to determine which funds were used in the study and how they were compared.

Broad Criteria

• Institutional funds with minimum initial investment of $25,000 or greater were eliminated.
• Funds that are closed to new investment were eliminated.
• Funds with less than one year of history through 12/31/2000 were eliminated.
• For the small-cap comparison, only funds that fell in the Morningstar style boxes 7-9 were used. (7 being small value, 8 small blended, and 9 small growth).
• For the small-cap growth comparison, only funds from style box 9were included.
• For the small-cap value comparison, only funds from style box 7 were included.

Benchmark Criteria

• Benchmark had to be from the appropriate style box for the category (style box 7-9 for small, style box 7 for small value, and style box 9 for small growth).
• Benchmark had to be a passive index fund.
• Benchmark had to be an investable fund (not closed, not institutional, and currently available for purchase by U.S. retail investors).
• Benchmark had to have sufficient history to be included, wherever possible (for small value, there was no index fund with any history of longer than three years. Also, many style and size ETFs were launched in 2000, and while they do not have the track record to be included in the study, may ultimately prove to be worthy category benchmarks. Vanguard also now has low fee small growth and value index funds).
• Benchmark with the lowest expense ratio was chosen as category benchmark once all other criteria were met.

Following is a brief survey of the results. All data is from Morningstar as of December 31, 2000.

Part I: Small-cap active funds vs. Vanguard Small Cap Index Fund (NAESX)[/:Author:]

Period: 15 years ending 12/31/2000 Field: 64 Benchmark Return: 10.90% Winners: 22 Losers: 42	Period: 10 years ending 12/31/2000 Field: 114 Benchmark Return: 16.21% Winners: 31 Losers: 83
Period: 5 years ending 12/31/2000 Field: 359 Benchmark Return: 11.46% Winners: 137 Losers: 222	Period: 3 years ending 12/31/2000 Field: 604 Benchmark Return: 5.34% Winners: 270 Losers: 334
Best Active Year 1991-2000[/:Author:] Period: 2000 Benchmark Return: -2.53% Field: 796 Winners: 478 Losers: 318	Best Passive Year 1991-2000[/:Author:] Period: 1992 Benchmark Return: 18.20% Field: 133 Winners: 30 Losers: 103

The study arrived at similar results for both small growth and small value categories as well. Though the available data for those sectors was more narrow, the results were nearly as conclusive. Of the data set (1-year, 3-year, 5-year and 10-year for small growth and 1-year and 3-year for small value) passive funds won in 4 of 6 time periods. For a complete outline of the data, please refer to The Index Insider, the Index Funds subscription-based newsletter.

In summary, it seems that the cardinal rule that drives index investors to common sense holds true for small-cap funds. That is, high costs/ high expenses are the best determinant of underperformance for a mutual fund. These costs, brought on by research expenses and trading costs, coupled with the tax consequences of high-turnover active management, force a fund's manager to outperform the benchmark by its alpha minus the fund's costs if outperformance of the benchmark is the desired end.