Small-cap has become on of the hottest asset classes with consultants and pension plans over the past few years. Ever since the ground-breaking work of Banz and Reinganum, small-cap stocks have been treated as a different asset class. Research in this guide will look at different small-capitalization style managers relative to a core manager. We hope this guide will provide new insights into small-capitalization stocks that are useful to pension sponsors, consultants and money managers.
Table of Contents:
SMALL CAP INVESTMENT GUIDE
Russell 2000 Versus S&P SmallCap 600: Beauty Is in the Eye of the Beholder 7
A. Seddik Meziani
This study examines the performance gap between the S&P SmallCap 600 and the Russell 2000. Analysis of the monthly performance differences between the two shows that the S&P 600 outperformance over the Russell 2000 has been fairly persistent since most years the S&P 600 outperformed the Russell 2000. An examination of the benchmarks in terms of their makeup, reconstitution methodologies, sector weights, and several other factors that might explain the gap reveals that there is reason to believe that the Russell 2000 performance distortions following its June 30 rebalancing date each year might be the most important cause. In spite of these post-rebalancing effects and their negative drag on performance, it's not obvious that the S&P 600 is the superior benchmark.
Does Active Management Work for Small-Cap Stocks? 17
David M. Blitzer and Srikant Dash
It is commonly believed that active funds perform better than indices in the small-cap market because of that market's relative inefficiency. In this article, we show that two issues-measurement techniques and benchmark selection-significantly affect any evaluation of active-management performance in small-caps. Specifically, we argue that correcting for survivorship bias, using asset-weighted fund returns, and substituting the S&P SmallCap 600 for the Russell 2000 as a benchmark paints a far less rosy picture of active management in small-caps than is commonly believed.
Extreme Investing: Using Extreme Data to Find Value in Small-Cap Stocks 21
Brian Bruce and Daniel Morillo
Researchers have looked into valuation effects for decades. Their research has usually focused on large-capitalization stocks. Not as much research has been done on valuations in small-capitalization stocks, as there is a tendency by many to associate small-capitalization stocks with a growth style. Any research that has been done on small-capitalization stocks was usually been confined to the lower deciles of the Center for Research in Security Prices data as this is the data set that academics had easy access to. This article presents valuation research on small-capitalization stocks as defined by the Russell 2000 index, which is the index used by most institutional investors to represent small-capitalization stocks. The results will show that while valuation is still an effective way to manage portfolios, certain characteristics exist at the extremes in the universe of data that make small-capitalization stocks behave differently from large-capitalization stocks.
Are Micro-Cap Stocks a Valid Asset Allocation Alternative? 39
Frank J. Travers
It is a well-known maxim in the investment business that inefficiency breeds opportunity. While the U.S. equity market is the most efficient in the world, micro-caps represent perhaps the only realistic exception to that rule. In many respects, the micro-cap portion of the U.S. equity market is the Wild West of the investment landscape. This universe is by far the largest and arguably the most dynamic component of the U.S. equity market, yet it receives very little attention from institutional investors. This lack of attention is key to the sector's attractiveness. Highly illiquid and volatile, however, micro-caps are not for the fainthearted.
Size and the Domino Principle 51
Satya Dev Pradhuman, Mohamed Chbani, and William Kan
The rotation in size appears to swing like a pendulum through the entire equity market. A bull market for large cap stocks not only suggests that the largest companies within the large cap market dominate, but also the largest companies within the small cap market. As the market moves in a direction in favor of small or large, it appears that the rotation in size cascades across the market like a domino effect.
The high correlation between the small cap cycle and an equal-weighted versus a market-weighted index supports the marginal effect-or domino principle-that operates across the equity market. This finding leads to several powerful investment implications: The domino principle suggests that size or market capitalization operates on the margin. As a result, active investors, both small cap and large cap, are forced to take a position on size. This effect also appears to exist across country markets. Active, not passive, strategies work better as lower capitalization stocks outperform. Conversely, passive strategies dominate in a large capitalization dominant market.
Chronology of Controversial Practices in a Microcap Company 60
Richard Chen
Microcap companies are thinly capitalized issues that are typically not qualified for listing in national exchanges. They are also referred to as penny stocks. A typical microcap issue has very few market makers. Moreover, trading in OTCBB and Pink Sheets is often sporadic and erratic. Thin trading of a stock ensures that a few market makers can easily control the market. The absence of rigorous listing requirements as well as the high possibility of price manipulation makes microcap issues easy targets for fraudulent activity. In this article, the author examines an obscure microcap, Ziasun Technologies Inc., whose practices are very controversial. At the time of this writing, the company has not officially been charged by the SEC for violating any securities laws. Although no attempts have been made to prove their activities as illegal in an official capacity, their practices are at best disingenuous to the general public. Any company engaging in these activities should raise red flags for prudent investors
An Analysis of Morningstar's Classification of Small-Cap Mutual Funds 69 72
The objective is to determine the usefulness of the Morningstar category ratings and star ratings as a composite risk/return measure of fund performance for small-cap mutual funds. Using the Tukey-Kramer method, analysis of the funds is done to determine whether investment style and performance variable are associated with differences in Morningstar's star ratings and category ratings. Although the category rating is preferred to the star rating, neither captures the entirety of the Sharpe Index.
Style Investing-To Be or Not To Be 75
Edward Kung and Larry Pohlman
The institutional community has strong prior belief that vastly different skill sets are needed to manage value and growth portfolios. Therefore, having separate value and growth managers should enable pension plan sponsors to maximize the ability to pick value or growth stocks and ultimately achieve superior performance. This article exams the differences between hiring value and growth managers or hiring a core manager. The results show that investors would have been better served by hiring a core manager with broad knowledge and latitude in investing in small companies, rather than managers constrained by the classic value and growth style subsets. For small-cap managers, core outperforms the combined value and growth approach with lower overall risk and better risk-adjusted returns both in the short (six years) and long term (15 years).
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