Small-cap funds are struggling

Small-capitalization mutual funds, representing one of the few areas where investors usually can justify the added cost of…

Small-capitalization mutual funds, representing one of the few areas where investors usually can justify the added cost of active management, have fallen down and can’t seem to get up.

Through the first nine months of this year, only about a quarter of actively managed small-cap mutual funds were able to keep pace with the benchmark Russell 2000 Index, which gained 14.2%.

The average gain of such funds during that period was 12.6%, according to Morningstar Inc.

This isn’t a simple case of the much-maligned practice of closet indexing. It is worse than that because at least with closet indexing, the funds have a chance of keeping up with the index.

Although it isn’t unheard of for a majority of active funds to lag behind the benchmark, it is rare in the small-cap arena, where active managers are expected to have a value-adding advantage in a universe full of lesser-known —and less covered — smaller companies.

For some perspective, consider that last year, when the benchmark lost 4.2%, it beat 39% of active small-cap funds.

“You have been hearing a lot over the past few years about how it is getting harder for active managers to beat an index, but seeing it like this in the small-cap space is a little unusual,” Morningstar fund analyst Katie Reichart said.

The last time the Russell 2000 so badly trounced active managers in the small-cap universe was 2006, when the index gained 18.4% and beat 83% of the funds in the category, which produced an average gain of 13.2%.

UNFAIR COMPARISON?

Some might argue that it is unfair to compare the performance of the Russell 2000 with that of actively managed small-cap funds, considering that the index represents the 2,000 smallest stocks in the Russell 3000 Index, which comprises the 3,000 largest public companies.

But active funds don’t look any better this year when compared with index funds pegged to other small-cap benchmarks.

The Vanguard Small-Cap Index (NAESX), for example, tracks the MSCI U.S. 1750 Index of smaller-company U.S. stocks.

That particular MSCI benchmark represents about 12% of capitalization of the U.S. equity market.

The Vanguard index fund had gained 14.9% year-to-date through last month. If the index maintains its top-quartile position over the next three months, the fund will have its best calendar year return, relative to the active category, since it started tracking the MSCI U.S. 1750 in 2003.

One theory explaining the generally lagging performance among small-cap managers is that the active portfolios have become too defensive during this period of sustained macroeconomic uncertainty.

“I don’t know if they’re reflecting the hesitation of investors in general or what, but small-cap managers usually have an advantage over other active managers because they’re dealing with a smaller-cap and less liquid market,” said Jeff Tjornehoj, head of Americas research at Lipper Inc.

An analysis of the average sector weights across active funds compared with the sector weights of the Russell 2000 suggests that active managers are “failing by just a few points,” he said.

The financials sector, for example, which represents 21% of the Russell 2000, has contributed 3.8% of the index’s performance this year.

Meanwhile, the average weight in financials for active managers was 18.6%, contributing just 2.8% to the overall performance.

It is a similar story with the health care sector, where the benchmark weight is 12.8%, contributing 3.4% to the overall performance.

But the active-manager average weight in health care stocks is 10.7%, contributing just 2.6% to the overall performance.

Then there is the generally more conservative industrials sector, which makes up 16.4% of the benchmark and has contributed 1.5% to the overall performance.

But the active managers had an average weight in industrials of 19.3%, which has contributed to 2.3% to the overall performance.

The distinctions might seem subtle, but as Mr. Tjornehoj put it: “It is death by a thousand cuts.”

In all fairness to small-cap active managers, it is worth pointing out that the category experienced $9.5 billion in net outflows over the first nine months this year.

That pattern might help explain why small-cap managers on average are holding nearly 4% in cash, while indexes have no cash weighting.

The bottom line is, advisers and investors should understand that active management among small-caps costs a full percentage point more than an index strategy, and right now, that looks pretty expensive.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected] Twitter: @jeff_benjamin