Equity Market Subsets

Breaking the market into fund subsets, based on portfolio characteristics, makes little sense for creating performance benchmarks. To explain why, let’s focus on the widely accepted manager characteristic based subsets of large-cap value, large-cap growth, small-cap value, and small-cap growth. The first question one might ask is why these particular subsets? The reason is that research beginning in the 70’s revealed that small capitalization stocks outperformed large stocks and low PE stocks outperformed high PE stocks even after adjusting for risk. This meant that a manager who bought small, low PE stocks could beat the market, or so it seemed at the time. In 1984 the first 2 x 2 manager “style grid” was introduced and the subset-ing of the manager market began. To understand what this means for performance evaluation, consider the 1982 – 2007 average annual returns for the S&P 500 and the four style indices shown below (Source: December 2007 Zephyr data base).

A manager’s performance is compared to one of the four style benchmarks, depending on how categorized, rather than to the market. Let’s say a manager is categorized as a large-cap value manager (more about the problems associated with this process later). Then to be considered successful, a manager would have to earn a return greater than 14.93% rather than 14.19%. What happens to the 74bp difference between the style and market benchmarks? The manager does not get credit for it because the performance benchmark has been increased by this amount. From an investor standpoint, this only makes sense if the additional 74bp is a reward for risk or if the investor can easily capture the additional return on their own. Neither of these hold up in light of the evidence

First, there is no agreement on whether the extra returns to size and PE are rewards for risk or simply a mispricing opportunity. So we really cannot say the 74bp is compensation for risk. Second, there are a number of problems with the investor picking up this return on their own. You will note in the table above that over this 26 year period large-cap outperformed small-cap stocks, just the opposite of what the initial research showed. So, is there a small firm or large firm effect? We need to know this to tilt the portfolio in order to earn this additional return. In terms of the so called value premium, a January 2007 study by Phalippou found that it disappears for those stocks largely held by institutions (93% of market capitalization). This means that the PE related value premium is unavailable to fund managers. So if there is no consistent size effect and no value premium, how can an investor or advisor go about picking up the 74bp through long term portfolio tilting? The answer is they can’t.

How about placing short term style bets rather than executing a long term portfolio tilt? Here the evidence is not very encouraging. The general conclusion is that managers have stock picking skill but no style timing skill. If the fund managers cannot style time, then how likely is it that investors or their advisors can? Instead, why not allow managers an opportunity to capture, indirectly, this premium through their stock picking rather than taking it away by changing benchmarks. This is quite different from the current practice of saying, after the fact, the manager did well, not because the strategy was successfully pursued, but because the portfolio was tilted towards large-cap value stocks and they happen to do well. The moral is don’t “Monday morning quarterback” the manager if you are unable to pick up the additional return yourself.

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