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 July 2010 S'Wonderful, S'Marvelous, SMID Sometimes You Need to Think Outside the Stylebox
Now equity investors of all stripes seek to build portfolios combining various capitalizations and investment styles based on what they deem to be the "best" from each specific category or subcategories of alternatives. Managers aren't just evaluated on their results but rather against others in their particular category. Performance doesn't simply have to be good, it has to be better than the appropriate benchmark.
The virtue of style based investing is somewhat arguable, but in some instances it's not. Some of the best managers don't fit into narrow categories. For example, the best "all cap" managers by definition have to be free to roam all across the stylebox in order to best ply their trade. The fact that they don't really fit into one specific stylebox should not be seen as a strike against them. In this case, this is obvious, but there are other instances where it's not as obvious but just as bad -- if not worse.
The Small Cap Manager's Dilemma To understand why, consider how small cap investing works. Small cap equities are generally those with a market capitalization of $300 million up to $2 billion. Anything smaller than $300 million is considered a micro cap and stocks with a capitalization greater than $2 billion are mid caps. Small cap managers are typically compared against the Russell 2000 or the S&P Small Cap 600. Style based investors see no problem with this. But for long term investors and the managers themselves, there's a terrible problem here: Success. Put yourself in a small cap manager's position. You scour the universe of stocks falling within the small cap capitalization range. You apply your evaluation procedures and select your best picks. If you're right, your stocks will start to appreciate carrying their capitalization along with them. So far, so good, but what happens when if they're really successful and end up with a market cap exceeding $2 billion? If you're truly sticking to your small cap mandate, you need to remove them from your portfolio and replace them with true small caps. But there are two problems with this. First, you're forced to sell stocks that are on a run. As they grow and become more well-known, other managers will want to buy them helping to sustain their price gains, yet you'll have to forego this to remain true to your small cap mandate. Secondly, and perhaps more importantly, if you choose to sell them when they exceed small cap capitalizations, you'll be forced to replace them with stocks of lesser conviction. All else being equal, you would prefer to stick with your winners which were, after all, your first choice. Once you sell them you'll have to pick up shares that you previously passed over. In essence, you have to dump your first choices in order to buy your second or third. Why would you want to manage your portfolio in this manner or why would you want to tie the hands of your small cap manager? Proponents of style based investing will argue that it's necessary to maintain style purity in your portfolio. If, for example, you wish to allocate 10% to small caps but your small cap manager retains winner that are now mid caps, your asset allocation is compromised. To make it work properly, your managers must remain style pure. If you small cap manager has to sell mid cap winners, presumably your mid cap manager will pick them up.
They'll also caution you to any such bleed over from one capitalization or style to another will undermine your ability to truly gauge the performance of your managers or portfolio. If your small cap manager holds a significant weighting in mid cap stocks, then a small cap benchmark will be inappropriate. The manager is essentially gaming the index. There's certainly something to be said for applying the appropriate benchmark when evaluating performance. On the other hand, there's little to be gained if in order to do so, you must sacrifice returns. After all, relative results are nice, but it's real return that you take to the bank. There's actually a better solution.
A Broader, Truer Category The concept is simple, but the results can be profound. Rather than having to sell winners and pick up second or third choices, adept small cap managers could ride the fruits of the labors all the way from small capitalization up to large. The ability to hold on through the mid cap range also opens up the top capitalizations of small cap for investment. Many managers shy away from stocks in the $1.7 - $2 billion range knowing it won't be long before they'll have to dump them when they cross into mid cap range. Smid managers don't have this fear. Trading expenses are also reduced. Smid managers don't have suffer the double indignity of incurring the expense of selling their successful small caps and buying lesser stocks. On the mutual fund front, small cap mutual funds tend to have the some of the highest expenses of all domestic funds. Anything to help hold that down is good in its own right. And speaking of mutual funds, the smid approach also helps control unnecessary capital gain distributions. The ability to hold onto growing small caps removes the necessity of generating unnecessary capital gains. It's one thing to face taxes when you have a valid investment reason to do so, but to pay them simply because a stock is doing well is pure folly.
Category Statistics
The S&P 1000 combines two leading indices, the S&P MidCap 400 and the S&P SmallCap 600, to form an investable benchmark for the mid-small cap universe of the U.S. equity market. S&P 1000 measures the performance of widely available and highly liquid stocks. This makes the S&P 1000 the appropriate mid-small cap index for investors seeking to replicate the performance of the U.S. equity market or serve as a benchmark for a universe of tradable stocks. Chart 1 compares the the year-to-date (through May 31, 2010), 1, 3, 5, and 10-year performance of S&P 1000 and the large, mid, and small cap indexes. As you'll notice, in each period it not only matches the highest return of the small and mid cap indexes, but holds it's value much better in the down markets. Chart 2 shows the risk and return for the indexes over the common period, January 1996 - May 31, 2010. Obviously this hasn't been a textbook fourteen-plus years because the indexes don't fall in a nice straight line with risk and return rising inversely with capitalization. Indeed, the relative positions change considerably in shorter five-year periods. The point is, however, the smid risk and return profile is more related to mid cap than small cap. This is most likely attributable to the cap weighting of the indexes. Chart 3 shows the index statistics in greater detail, once again pointing up the similarities between the S&P 1000 and the Mid Cap 400. Returns are just shy of the Mid Cap 400's, the standard deviations are almost identical, and the Sharpe Ratio is just slightly under that of pure midcaps. Small caps had lower returns and higher risk, leaving their Sharpe Ratio below that of both the 400 and 1000. That's part of the benefit of using a smid approach: As your small cap stocks grow up, you not only get to hold on for a longer ride, your risk declines in the process. All told, there are a number of reasons to employ a smid approach in a well-built portfolio. The statistics show the value, transaction and capital gains expenses are reduced, and the availability of an easily accessible benchmark provides a means for comparison as well as a proxy for mean-variance portfolio modeling. This is clearly one of those instances where it really does make sense to think outside the stylebox. Search this site! Just enter you key word or words:
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TYLE BASED INVESTING became the rage over the past twenty years. Prior to that, investors used to look for the best stocks or investments wherever they could find them, built a portfolio, and compared its performance to that of a broad market benchmark. But risk levels differ and various parts of the market perform differently than others. To take advantage of this and provide more appropriate benchmarking, academics suggested diversifying across distinct market segments and evaluating performance against style-specific indexes. Morningstar got retail investors focused on clearly defined categories arrayed in their equity and fixed income styleboxes.
