One frequently hears active managers claim that they avoid the large-cap U.S. market because it’s too hard to find undervalued stocks. By that reasoning, actively managed small-cap international funds should be alpha-generating powerhouses. Let’s see if that’s true.
Previously, I’ve examined the ability of domestic, actively managed small-cap funds to add value. My analysis showed that if you had a perfectly clear crystal ball and could identify which funds would be the largest actively managed funds at the end of a 15-year period, it’s likely that you would have outperformed passive strategies.
However, I also showed that, even with such foresight, these top-performing funds were unable to generate sufficient alpha to overcome their expense ratios and other costs. On average, the 10 largest funds produced a slightly negative alpha — though the negative alpha was smaller than their expense ratios.
I’ll now turn my microscope on international, actively managed small-cap funds, an asset class that active managers claim is even more inefficient than domestic small-caps. As I did with my analysis of domestic actively managed small-cap funds, to keep the list to a manageable number of funds, I have selected to analyze the performance of the 10 international developed small-cap funds with the largest amount of assets under management (AUM) as of the end of 2015.
To ensure that I examine long-term results through full economic cycles, as I did with the domestic small-cap fund analysis, I’ll analyze fund performance over the 15-year period ending December 31, 2015. When there is more than one share class of fund available, I will use the lowest-cost shares obtainable for the entire period. Later, I will expand my evaluation to include the entire universe of funds that survived the period under review.
As I observed in my article on the domestic small-cap funds, this methodology creates a substantial bias in the data. I am considering only funds that survived the full period, and a significant amount of all mutual funds disappear each year. Second, the AUM of a fund that has outperformed its benchmark will benefit not only from that strong performance, but it will also benefit from the investor cash flows that tend to follow.
Thus, the funds with the strongest past returns will tend to be the largest. This doesn’t mean that investors actually earned the same returns over the full period since they may not have been invested over the full term. Therefore, the results are not truly reflective of what investors in these actively managed funds actually secured — they are biased upward.
We should expect the funds with the most AUM to have outperformed, although the research shows that their large asset size is likely to hinder future performance. The larger questions I will answer are the following: First, if you were smart (or lucky) enough to identify these 10 stellar performers ahead of time, by how much did you benefit compared to using passive alternatives? Second, was it worth the risk that you might have been wrong in your choice?
With the aforementioned bias in mind, the table below shows the performance data for the 10 largest actively managed small-cap funds as of year-end 2015. My standard practice is to compare the returns of these funds to the returns of comparable funds (based on Morningstar’s categorization) from the leading provider of index funds, Vanguard and the structured portfolios from Dimensional Fund Advisors (DFA), a leading provider of passively managed asset class funds. (In the interest of full disclosure, my firm, Buckingham, recommends DFA funds in the construction of client portfolios.)
DFA funds can be purchased through some 529 and 401(k) plans, but generally they are available only through an advisor. An investor would incur fees from that advisor; those fees vary greatly (in some cases they are very low) and cover the full range of financial planning services provided by the advisor. Also, John Hancock recently introduced a series of ETFs that are managed by DFA (with expense ratios that differ from the DFA funds cited in this article). Those ETFs can be purchased directly by investors. All Vanguard funds can be purchased directly by investors.
Unfortunately, Vanguard doesn’t have any index funds that meet my requirements. As a result, while my preference is to use live funds as benchmarks (so we can see realizable returns, after implementation costs), I’ve used the MSCI World ex-U.S. Indexes as benchmarks in place of the Vanguard funds. In addition, for international funds, Morningstar combines small-cap and mid-cap funds into one category. Thus, the comparisons may not be as “apples-to-apples” as the domestic comparisons.
The returns data covers the 15-year period ending December 2015.
|
Fund
|
Symbol
|
Expense Ratio
(%)
|
Annualized Return
(%)
|
|
International Small/Mid Growth
|
|
|
|
|
Columbia Acorn International
|
ACINX
|
0.93
|
7.5
|
|
Oppenheimer International Small-Mid Co. A
|
OSMAX
|
1.20
|
13.5
|
|
MFS International New Discovery I
|
MWNIX
|
1.07
|
9.1
|
|
T. Rowe Price International Discovery
|
PRIDX
|
1.21
|
8.5
|
|
VALIC Company II International Opportunities
|
VISEX
|
1.00
|
4.1
|
|
Average
|
|
1.08
|
8.5
|
|
MSCI World ex-U.S. Small Cap Growth Index
|
|
|
6.1
|
| |
|
|
|
|
International Small/Mid Blend
|
|
|
|
|
Vanguard International Explorer
|
VINEX
|
0.40
|
7.3
|
|
Oakmark International Small Cap I
|
OAKEX
|
1.31
|
9.9
|
|
GMO Foreign Small Companies III
|
GMFSX
|
0.85
|
10.7
|
|
Lord Abbott International Opportunities I
|
LINYX
|
1.07
|
4.7
|
|
Average
|
|
0.91
|
8.2
|
|
MSCI World ex-U.S. Small-Cap Index
|
|
|
8.6
|
|
DFA International Small Company I
|
DFISX
|
0.53
|
9.4
|
| |
|
|
|
|
International Small/Mid Value
|
|
|
|
|
Brandes International Small Cap Equity I
|
BISMX
|
1.15
|
10.8
|
|
MSCI World ex-U.S. Small Value Index
|
|
|
9.8
|
|
DFA International Small Cap Value I
|
DISVX
|
0.68
|
10.8
|
The following is a summary of the results:
- Relative to the MSCI Index benchmarks, three of the 10 largest actively managed small-cap funds underperformed. The active funds also were able to outperform, on average, in two of the three asset classes. Equal-weighting the three fund categories, the active funds’ average outperformance was by 1.0% (9.2% versus 8.2%).
- Relative to DFA’s structured portfolios, and where comparable funds were available, two of the five largest active small-cap funds underperformed (the average underperformance was by 3.4%), two outperformed (the average outperformance was by 0.9%) and there was one tie. Equal-weighting the pair of fund categories for which there are comparable funds, the five actively managed funds underperformed by 0.9%.
There’s one more important point to consider when evaluating the returns data in the table, which showed that six of the nine international small/mid growth and blend funds beat their MSCI benchmark index. Both the international small/mid growth and small/mid blend indexes underperformed the small/mid value index.
That brings us to what’s known as Dunn’s Law (named for the Southern California attorney who provided the insights). Dunn’s Law states that when an asset class underperforms, active managers in that asset class have a greater chance of outperforming their benchmark index. The logic is simple. Index funds can generally achieve the greatest exposure to the relevant risk factor responsible for the vast majority of the asset class’s returns, while active managers have the ability and tendency to “style drift.” In this case, it’s possible that the six growth and blend funds that beat their benchmarks did so because they style drifted and owned small value stocks, which produced higher returns than the benchmark. If this was the case with domestic funds, it would be revealed through a regression analysis. Unfortunately, the same regression tools are not available for international funds. Keep Dunn’s Law in mind as you read on.
Thanks to S&P Dow Jones Indices, we can take a deeper dive into the pool of actively managed small-cap funds. And we’ll do just that by reviewing the results of its year-end 2015 SPIVA scorecard.
SPIVA scorecard results
The SPIVA scorecard has the benefit of eliminating survivorship bias. The longest period for which the report provides performance data is the 10-year period ending December 2015. The following is a summary of its key findings:
- A majority, 62.5%, of actively managed international small-cap funds underperformed their index benchmark.
- 81.3% of actively managed international small-cap funds that existed at the start of the period managed to survive the full period. This demonstrates that there is a large survivorship bias if one is looking only at surviving funds, as Morningstar does in its performance rankings.
- On an equal-weighted basis, the average actively managed international small-cap fund returned 5.5% per year and outperformed the benchmark S&P Developed World ex-U.S. SmallCap Index by 0.2%. On an asset-weighted basis, the outperformance was 0.7% per year.
The SPIVA report also looked at the performance of actively managed funds in emerging markets, the asset class that active managers generally claim is the most inefficient. Note that in emerging markets, the SPIVA scorecard reports all funds in one broad category (regardless of market capitalization or value-growth orientation). The following is a summary of the results:
- 91.4% of actively managed emerging market funds underperformed their benchmark, the S&P/IFCI Composite Index.
- 78.6% of actively managed emerging market funds survived the full period. On an equal-weighted basis, they returned 3.1% per year and underperformed their benchmark by 1.6%. On an asset-weighted basis, the underperformance was 0.9%.
Overall, the results from the SPIVA data are mixed. While the majority (62.5%) of actively managed international small-cap funds underperformed their benchmark, the average fund outperformed by 0.2% on an equal-weighted basis and by 0.7% on an asset-weighted basis. However, in emerging markets, no matter how you slice it, the performance of active managers was awful.
The results shown above are on a pre-tax basis, and the research shows that, for taxable investors, the largest cost of active management isn’t typically a fund’s expense ratio or its trading costs. Instead, taxes are often the largest expense. Thus, for taxable investors the odds of winning are dramatically lower than indicated by the SPIVA data.
A deeper dive
Using Morningstar’s database, I will now take a look at the full universe of actively managed international small-cap funds with 15-year track records for the period ended December 2015.
Unfortunately, unlike the SPIVA data, Morningstar’s data includes only live funds. That creates the problem of survivorship bias, which should be kept in mind as you review the results. In addition, in the case of international funds, Morningstar combines the small-cap and mid-cap asset classes into one category. As is my practice, I’ll compare the returns of active funds to the returns of passively managed DFA funds in the two categories of small/mid blend and small/mid value (Vanguard doesn’t have any international small-cap index funds, and DFA doesn’t have an international small-growth fund).
Small/mid blend funds
There were only seven active funds in this category. Their average return was 8.2%. There is no Vanguard index fund in this category. The DFA International Small Company Fund (DFISX) returned 9.4%, outperforming the average actively managed fund by 1.2%.
Investors are not only concerned with the odds of out/underperformance, but also with how much they might out/underperform. Three of the actively managed small/mid blend funds (42.9%) outperformed DFISX, with an average outperformance of 1.0%. However, the four actively managed funds (57.1%) that underperformed did so by a much greater average underperformance of 2.8%.
The finding that the funds that underperformed did so by a greater amount than the funds that outperformed is consistent with the findings from other studies. In this case, the risk-adjusted odds against outperforming the passively managed fund were 3.7:1.
Small/mid value funds
There were six actively managed small/mid value funds in this category. The average return was 6.7%. The DFA International Small Cap Value Fund (DISVX) returned 10.8% and outperformed the actively managed funds by an average of 4.1%.
The Morningstar data clearly shows that active management is just as much a loser’s game in the supposedly inefficient asset class of international small-cap stocks as it is for U.S. large-cap stocks. And while it certainly is possible to outperform a comparable passively managed fund, the odds of doing so are so poor that it’s not prudent to try. Again, the Morningstar results shown above are on a pre-tax basis. Thus, for taxable investors, the odds of winning are dramatically lower than indicated in the preceding results.
Summary
If you had infallible prescience and could identify which funds would be the largest actively managed funds at the end of a 15-year period, it’s likely that you would outperform the benchmark indexes. However, you would have underperformed the passively managed funds of DFA.
Unfortunately, mere mortals lack that foreknowledge.
In addition, there’s little evidence that investors, even sophisticated institutional investors with access to far more resources than individuals, have been able to identify the few future winners in advance. In fact, the research shows that the managers that pension plans fire due to poor performance tend to go on to outperform the managers that were hired to replace them.
Given the poor performance of actively managed international small-cap funds relative to passive indexes and DFA’s passively managed alternatives, the winning strategy in this asset class is to choose well-designed, passive funds that provide the desired amount of exposure to the factors (such as size, value, profitability/quality and momentum) to which you want capital allocated.
Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.
Disclosure: The corresponding portfolios are provided for informational purposes only. The returns data included is from Morningstar, and the factor analysis tool was provided by Portfolio Visualizer. Performance is historical and does not guarantee future results. Information is from sources deemed reliable, but its accuracy cannot be guaranteed. It should not be assumed that any of the securities listed were, or will prove to be, profitable.
Read more articles by Larry Swedroe
