Small cap actively managed vs. ignoring small-cap?

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peteyperson
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Small cap actively managed vs. ignoring small-cap?

Post by peteyperson »

In the UK market and indeed in Europe, there is not to my knowledge a way to index small-cap equities. Indeed, there still isn't a way to index mid-cap but a UK ETF is coming out to solve that one.

So I'm wondering. Do you buy the best actively managed small-cap fund or do you just ignore the asset class altogether? A small-cap fund has a 5.25% load and 1.76% fees per year approx.

Part of the answer may hinge on an investment timeline from age 35 to age 85, 50 years, and whether any actively managed fund makes sense to a buy & hold investor in such a scenario. The fund managers will have to change during that timeline, perhaps several times over vs. an index that uses a methodology instead of a star manager (though clearly managing index funds is a skill all its own). Do any actively managed funds make sense for a long term investor?

Workarounds could include overweighting US small-cap to balance out a large-cap overweighting in UK, European and other locales generally invested via a market-cap weighted index fund which captures much more of large than mid or small cap a la Wilshire 5000.

Thoughts?

Petey
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Alec
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Petey

Post by Alec »

I'd most likely forgo (sp?) the UK and Europe small cap in favor of U.S. small cap. Here are some correlations b/w asset classes from the "Intelligent Asset Allocator":

http://www.bylo.org/uscorel.html

Note the lower correlation b/w the MSCI EAFE and US small cap than b/w the EAFE and UKSM (United Kingdom Small cap). You'll also notice the same deal comparing the US large caps (S&P 500) and Int'l Small caps with US large caps and US small cap.

Also note that the CRSP 9-10 decile are used for a proxy for US small caps. I don't believe that there are currently any US index mutual funds or ETFs available (to the small investor) that are as "small" as the 9-10 decile. Bridgeway's Ultra Small Cap Tax Advantaged fund does use mainly small caps that are this "small", but I think that it may be closed to new investors. I believe the only index mutual funds and ETFs for US small caps use either the S&P 600 index or Russell 2000 index. These are not as "small" as the 9-10 decile. Of the S&P 600 or the Russell 2000, I'd use the S&P 600 since the Russell 2000 can be "gamed" by investors.

Having said that, I think a low cost US small cap ETF will provide better diversification from your UK and Europe Large caps than a UK or Europe small cap fund (especially at those high fees). I think Small caps tend to be affected more by country/region specific economic events and factors, and less by international influences than large caps. I think the same argument may also fly for value stocks of different countries and regions as opposed to growth stocks of different countries and regions. U.S. small value may even be a better diversifier than general U.S. small cap (which would include small value and growth).

So, you may wish to use U.S. value funds/ETF's and U.S. small funds/ETFs in place of some of the U.S. large cap (S&P 500). Some don't use int'l large caps (blend or growth) at all. However, this strategy should provide some SERIOUS tracking error, so be prepared to underperform the overall markets for periods of time.

If I was going to use an actively managed fund, I'd look for low turnover (especially in small caps b/c of the higher bid/ask spreads), very stable management (a management team would be even better), no style drift (like going from growth to value and vice versa), and hopefully low expenses. The load and high expenses seem to totally rule out UK and Europe small caps for you.

I sure wish Barclays (in conjunction with DFA perhaps) would come out with some Int'l small cap ETFs for us U.S. investors.

- Alec
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ben
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Post by ben »

Great reply Alec!
I had the same considerations as Petey and was considering the managed intl small cap funds (believe Oakmark was one of them - no-load but high e/r. Artisan was another). But evaluating long term advantage of small caps vs large caps (using US stats) I concluded that the managed fund e/r+other costs would be too much of a drag, especially since the intl. small cap arena have high trading costs/bid-offer spreads which is NOT part of the e/r.

I also read in one of Bernsteins qtrly newsletter where he mentioned that he did not recommend the managed route either in intl. small caps due to the above.

Based the above my foreign asset classes simply became VEIEX/VPACX and IEV in even blocks which all, as Petey says, will be mainly large caps.

I then, as Alec suggested, increased my US small cap arena accordingly with the purchase of BRSIX (Bridgeway microcap fund-now closed for new investors).
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ataloss
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Post by ataloss »

nice link, bylo has an amazing amount of info!
Have fun.

Ataloss
peteyperson
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Re: Petey

Post by peteyperson »

Hi Alec,

Thanks for your interesting reply. I especially appreciate the link (great stuff to read there). Haven't bought Bernstein's first book (lower down the list to buy as I've got most of it from the more recent one) but had not found a correlation guide to help with such choices. With the correlation figures in the table, the answer jumps out at you! There's also a nice low correlation between REITS and EAFE which makes US real estate a good diversifier for me.
Alec wrote: So, you may wish to use U.S. value funds/ETF's and U.S. small funds/ETFs in place of some of the U.S. large cap (S&P 500). Some don't use int'l large caps (blend or growth) at all. However, this strategy should provide some SERIOUS tracking error, so be prepared to underperform the overall markets for periods of time.


I had indeed been considering the "raddr approach" of almost entirely small-cap value for US to balance out the total market elsewhere which in reality is cap-weighted heavily to large cap and unavoidable without the large fees as discussed. A punt into value would be interesting too as it is a small part of the total portfolio but would be an interesting experiment.

I think the way people here put together a portfolio, tracking error is not really the concern. On a single index fund, certainly, but you're trying to balance your risks in various market/investing/economic situations to provide liveable income from capital & divdends depending on the situation. The return on the S&P 500 would therefore not be too much of a concern as it would be others who are heavily weighted in one country, one asset class, one index.

The other day I thought about what I was trying to achieve and decided that I needed to break down different investments by their risks in different situations and how they comprised return either by capital or dividends or both. This led to some changes to my planned allocation in order to balance out risks, but also to ensure there was income coming in because of the allocation despite one major asset class like equities in general having problems. I sort of went down the list of problems, what if the global economy was screwed for 10 years, no capital return via a 50% drop in global equities valuation a la Chips scenario and if the planned allocation would weather that. What it cost in w/d rate to go more defensive by having less on equities and more elsewhere. Taken in that light, equities can have 20 down years with dividend income cut to a minimum and depending on the investment you select, low to high fees further increasing losses. They may be the highest returning asset class (depending on how good you think real estate has been) but their downside risk for someone living off their assets is seldom pointed out and quite extreme. So this sort of view from all angles helps a great deal in the planning and being reasonably comfortable that you've done the best you could do.

Follow-up Q. We have a UK mid-cap index ETF coming out shortly. For large cap index, we either have an equivalent of the S&P 500 or Wilshire 5000. Costs are pretty similar. If I avoid UK small-cap due to there being no low cost index option and overload on US small-cap instead, how would you split the UK market? Half & half, large and mid-cap to avoid quite so much large-cap EAFE overload?
Alec wrote: I believe the only index mutual funds and ETFs for US small caps use either the S&P 600 index or Russell 2000 index. These are not as "small" as the 9-10 decile. Of the S&P 600 or the Russell 2000, I'd use the S&P 600 since the Russell 2000 can be "gamed" by investors.


Could you pls clarify what you mean by "gamed" on S&P 600 vs Russell 2000. I was unclear which would be better on US small-cap investing. I had thought the Russell 2000 would be better unless I was going for a BARRA Value option.

Petey
Last edited by peteyperson on Mon Oct 13, 2003 5:59 pm, edited 6 times in total.
peteyperson
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Post by peteyperson »

Hey Ben,

It is good to read we are both facing similar issues and have seperately come up with the same kind of ideas at a solution.

My attitude to risk comes to the fore when I compute a higher expense ratio from active management and need to raise the expected nominal return to get the same net of fees return. I feel uncomfortable with raising the expected return and feel more comfortable with an indexed approach, planning for a lower return figure but having a lower downside and less optimistic/more realistic projections. Smaller fees reduce the downside on multiple down years too. I find I just can't swoller the higher fees, planning investments where they are cheapest.

A good example of this is REITs/Property. 5.25% load, 1.76% mgmt fees in the UK vs, 0.30% avg with broker fees to add-on. It makes you choose the US and to look for international REIT exposure like the Australian REIT recently discussed in order to balance out currency exposure. I would prefer some UK currency in every asset class but at times the costs are so extreme it is hard to do. I may well have to try to balance the currency over the whole portfolio and accept inbalances per asset class when investing for the lowest cost. I'm hoping for more options with an expanding range of international ETFs as time goes on.

Lately I've been toying with whether to have around 2% each in Asia Pacific, EM & an Oil, Gas, Timber, Pulp and/or Gold mining ETF. I've considered what projected return to put down and not been comfortable with projecting anything above 3% nominal. This puts the projection below what cash delivers pre-expenses and makes one question whether it is even worth investing in these asset classes when one holds little confidence of a solid long term return. This however would leave equities in UK, Europe ex UK and the USA, some USA REITS, UK, USA & Euro bonds and cash. Sort of one half of the globe exposure, ignoring the other side e.g. Asia etc. By taking a low-cost index approach, avoiding investing where the costs are too extreme, I can "afford" to allocate a small percentage to each of these asset classes in an effort to balance myself globally in higher risk investments and it leaves some upside room while covering downside risk.

Thoughts?

Petey
ben wrote: Great reply Alec!
I had the same considerations as Petey and was considering the managed intl small cap funds (believe Oakmark was one of them - no-load but high e/r. Artisan was another). But evaluating long term advantage of small caps vs large caps (using US stats) I concluded that the managed fund e/r+other costs would be too much of a drag, especially since the intl. small cap arena have high trading costs/bid-offer spreads which is NOT part of the e/r.

I also read in one of Bernsteins qtrly newsletter where he mentioned that he did not recommend the managed route either in intl. small caps due to the above.

Based the above my foreign asset classes simply became VEIEX/VPACX and IEV in even blocks which all, as Petey says, will be mainly large caps.

I then, as Alec suggested, increased my US small cap arena accordingly with the purchase of BRSIX (Bridgeway microcap fund-now closed for new investors).
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Alec
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Post by Alec »

Sorry. I should have called it "front running"￾. Here is an article on the S&P 600 vs. the Russell 2000 debate:

http://www.indexfunds.com/articles/2002 ... gen_JS.htm

Here an article on the Russell Indexes:

http://www.indexfunds.com/articles/2002 ... gen_JS.htm

The way the S&P/Barra splits Value and Growth (splitting the S&P 600 into value and growth halves by market cap, with the most expensive half of the market designated as growth, and the other half as value) results in the S&P 600 value containing both value and blend companies. So, it's not a pure value index.

I'll have to think a while about your other questions.

- Alec
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Post by ben »

Hi Petey,
I also avoid the Russel 2000 index. Bernstein also covered the subject in one of his qtrly newsletters (everybody should read them ALL I think).

I use the ETFs IJR and DSV in a 50/50% for my US small caps - giving it a value twist without leaving out SOME growth exposure.

As for your comments about risk/return/costs I fully agree. Actually for me there is one more side to it: the "feel-good" factor! I hate paying for someones Gucci suit and sportscar - EVEN if he ONE year (we all know the long run result) earned me more money (by luck!). I actually switched REIT fund from SSREX (1% e/r) to Vanguard VGSIX due to that. When I switched SSREX had the better (even longterm) historical performance but I figured; they must then also be taking on more risk+longer term they will lose out. It turns out I was right in the last year I believe - but even if I wasn't I would not regret - I chose the ASSET CLASS - not some fancy manager (getting soft $ in return etc.).

The book " Comfort zone investing" by Gillette E. covers the subject quite well. Easy read.

That said I DO like your idea of putting a LITTLE in areas where costs are prohibitive for it's rightfull share (you know my faith in Asia :wink:) - while the money might not be big it will make you feel better to know you are part of the game also when gold goes through the roof or EM/PAC keeps steaming ahead.

As I said before; with a 5-6% load and 2% e/r I would NEVER touch the products though - I would buy the US based ETFs/CEFs/ADRs through my bank or broker - saving a fortune.
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