Indexology^® Blog

If you found a small-cap fund with a 23 year track-record that performed in the top 10th percentile of its peers over a 3-, 5-, 10-, and 15-year period, might you consider investing?  How about if you found out it was also a fraction of the price of its peer group?  Sounds pretty attractive, but unfortunately, there isn’t really “a fund” like this.

However, there is an index called the S&P SmallCap 600 that has performance like this, and it is possible to replicate it.   In fact some managers already do replicate it, and with far lower fees than the average small-cap mutual fund. The industry average fee for a small-cap mutual fund is 1.37%, but there are ETFs that offer products tracking the S&P SmallCap 600 with expense ratios as low as 0.07%.  (Here is a more complete list of S&P SmallCap 600 linked products from our website.)

This is the 3rd part of our blog series containing excerpts from our new paper where we discuss the outperformance of the S&P SmallCap 600 versus the Russell 2000, the performance of the indices compared with active managers, and the case supporting the performance.

SMALL-CAP INDEX PERFORMANCE VERSUS THE ACTIVE SMALL-CAP PEER GROUP
As mentioned in the introduction, the SPIVA U.S. Mid-Year 2017 Scorecard shows the S&P SmallCap 600 outperformed 93.8% of all small-cap funds over a five-year period. Moreover, the report calculates that over the 1-, 3-, 5-, 10-, and 15-year periods, the S&P SmallCap 600 beat 59.6%, 88.7%, 93.8%, 94.1%, and 94.4% of small-cap mutual funds in the University of Chicago CRSP database, respectively. This challenge in beating the index may contribute to why only 3% of funds are benchmarked to the S&P SmallCap 600.

To investigate the performance of small-cap benchmarks relative to institutional active managers, we utilized data from eVestment Alliance. In Exhibits 6-8, we compared the S&P SmallCap 600 and Russell 2000 with two S&P DJI small-cap factor indices that have exhibited strong relative performance over the past 20 years. The S&P SmallCap 600 Low Volatility Index is designed to measure the 120 stocks within the S&P SmallCap 600 with the lowest historical volatility, as measured by the standard deviation of daily price returns over the past 252 trading days. The S&P SmallCap 600 Quality Index is designed to measure the 120 stocks within the S&P SmallCap 600 that have the highest average z-score, which is based on three quality metrics: return on equity (ROE), balance sheet accruals ratio, and financial leverage ratio.

As shown in Exhibit 6, the S&P SmallCap 600 outperformed the Russell 2000 in all periods studied, ranging from one year to the entire period since the inception of the S&P SmallCap 600. The S&P SmallCap 600 also outperformed the median small-cap fund in the 1-, 3-, 5-, and 10-year periods ending Sept. 30, 2017.

Exhibit 7 compares the returns of the S&P SmallCap 600 and Russell 2000 to the eVestment U.S. small-cap equity universe from 2007-2016. The S&P SmallCap 600 ranked higher than the Russell 2000 in seven years and tied in one year. Only in 2009 and 2010 did the Russell 2000 rank higher, with a 74th percentile ranking versus a 79th percentile ranking for the S&P SmallCap 600 in 2009, and a 59th versus 62nd percentile ranking in 2010.  In 2014, 2015, and 2016, the S&P SmallCap 600 ranked even higher, in the 45th, 41st, and 24th percentiles, respectively.

The three-year rolling periods are shown in Exhibit 8. There were a total of eight three-year periods, and the S&P SmallCap 600 ranked higher than the Russell 2000 over every period. The S&P SmallCap 600 was also competitive with the active manager universe, scoring in the top half in five of eight three-year periods.

The evidence of the S&P SmallCap 600’s outperformance over the Russell 2000 is clear, not just in plain comparison but juxtaposed to active managers. Conceivably, the S&P SmallCap 600 could be considered not just as a benchmark replacement, but rather it could more widely serve as the underlying index for investable passive funds.

We will explore the reasoning behind results this strong and steady in the next part of this blog series.

After Donald Trump became the 45th president of the U.S., the Dow^® hit the 20,000 mark for the first time in history, there was a total solar eclipse, along with massive hurricanes, floods in Colombia, earthquakes in Mexico, a referendum in Catalonia, and the New England Patriots made an historic comeback in Super Bowl LI, the Houston Astros won their first World Series, and Star Wars Episode VIII opened in movie theaters. Meanwhile, we can take a look how inflation, the reference rate, and currencies from Brazil, Chile, Colombia, Mexico, and Peru moved over the past year and how the sovereign indices of these countries performed.

First, we will take a look at the reference rate from the countries’ respective central banks. The big winners from 2017, in terms of number of movements over the past year, were Brazil and Colombia, which changed their reference rate eight times. Brazil moved it down 600 bps, from 13.75% to 7%, and Colombia moved it in the same direction, from 7.5% to 4.75%. Mexico was the only country (from the observed) that moved the overnight rate on the upside year-over-year, with five changes amounting to an increase of 150 bps, as it closed at 7.25%. Chile and Peru moved theirs -75 bps and -100 bps, respectively. Exhibit 1 shows the reference rates over the year.

In terms of currencies, Chile had the greatest appreciation of the year with 8.16%, followed by Mexico with 5.15%, and Peru with 3.52%. Colombia stayed almost the same, with an appreciation only of 0.65%, and the only currency that depreciated was the Brazilian real, down 1.81%.

As for inflation, Peru hit its lowest inflation level in 10 years when the year-over-year CPI for November came at 1.54%. Inflation in Brazil and Chile was on target (as set by their central banks), with 2.77% and 1.91%, respectively through November. Colombia closed November with 4.12%, while Mexico ended with 6.63%, beyond the ~2% target inflation set by Banxico. Exhibit 2 shows how inflation moved in 2017.

Taking a look at the sovereign indices of the nominal and real rate bonds, the big winner in terms of index performance was Peru. The S&P Peru Sovereign Bond Index closed the year with a gain of 16.98% and the S&P Peru Sovereign Inflation-Linked Bond Index increased 13.02%. On the nominal side, Peru was followed by Colombia and Mexico with gains of 9.02% and 6.59%, respectively. As for the inflation indices, Brazil was second with 12.23%, while Chile was the only country with negative returns for 2017, with -1.47%. Exhibit 3 shows the YTD and quarterly performance of the indices.

I can assure one thing that all Latin America will be expecting this year… and that’s the World Cup!

News that the Dow broke through 25,000 yesterday was not universally celebrated.  A market index achieved a specific numerical barrier — so what?  The importance of such events is at best anecdotal, and their celebration in the media is increasingly regarded as humbug.  Is there any truth – one might ask – to the theory that such events are “psychologically important”?  That is to say, do they change the behavior of market participants?

Certainly, some numerical values are of demonstrable psychological importance to humans undertaking economic transactions.  Otherwise, supermarket items priced at 4.99 instead of 5.00 monetary units would not sell disproportionately better.

Beyond the average supermarket shopper, or even the most cynical of market participants, nearly everyone has celebrated an anniversary or set a round number goal as an ambition.  To an independent observer, changes in behavior based on the achievement of arbitrary numerical values would seem a most human trait.   So it is logical to expect buyers or sellers whose motivating impulse was the price reaching a particular number to have some impact on capital flows, and therefore the markets.

However, even though investment flows are (for the time being) largely dominated by the decisions of humans, investing has become increasingly professionalized – and, increasingly, non-human.   Do so-called “psychologically important barriers” still exist in any real sense for market indices?  And even if they do, is there anything important about the Dow passing 25,000?

I suspect the impact of such occasions may be less material today than when markets were less professionalized.  Or, perhaps the particular barriers that are considered important will change.  The S&P 500 index today passed above the level of 2730 for the first time, which doesn’t sound very interesting to the average human, but in binary that means it has passed 101010101010.  Perhaps some computers are celebrating this fact as I write, perhaps – now that you know – you will, too.

Yet here I am, writing about the DJIA crossing through yet another 1,000 point milestone – 25,000, no less – a mere 23 trading days after the last one and right on the tail of the 5 successive 1000 point marks achieved last year.

With the 152.45 points (0.61%) gained during today’s session, the Dow closes at 25,075.13 and is up:

• 1.44% year-to-date (over all of 3 trading days)
• 27.08% since Trump’s inauguration (I’ll leave to others on where to ascribe credit)
• 283.00% since the Financial Crisis low of 6,547.05 hit on March 9, 2009
• 77.03% since the pre-Financial Crisis high of 14,164.53 hit on October 9, 2007

As for elapsed time, this 23 day sprint from 24k to 25k is – by a single day – the fastest the DJIA has ever covered that ground; the moves from 10-11k and 20-21k each took 24 days.  The returns for each climb, however, are markedly different:  10-11k represented a 10.1% return, for example, while the most recent mark is just a 3.31% increase.

And what are the drivers?  Following are top 5 point contributors to each of the most recent milestones as well as the march from 15k to 25k (which transpired from May 2013 to the present).  Boeing (BA) is the clear standout recently having contributed 17.7% of the run from 20-25k; as for the climb from 15-25k, Boeing was again the top stock followed by UnitedHealth Group (UNH) and 3M (MMM).

Again, when discussing this topic the standard caveats apply:  a) though the aggregate DJIA advance is certainly notable, each 1,000 point mark is, while an interesting emotional milestone, an otherwise arbitrary threshold, and b) as noted above, each new mark represents a smaller percentage gain than its antecedents.

By the way, if you’re looking for a “Dow 25,000” hat to add to your collection, don’t come to me.  At this rate, I don’t have the personal budget to keep printing them.

* – Don’t be confused as to how a 1,000 point milestone can be covered with 800 or 900 points.  Remember that for this exercise, we’re striking from the closing DJIA value on the day each milestone was crossed and these never land right on the even thousand point mark.  In the most recent case (24-25k), for example, the move was from 24,272.35 to 25,075.13 (or 802.77 points).

Not all indices are created equally, especially those representing US small-cap equities.  Many investors are surprised to learn that the S&P SmallCap 600 has outperformed the Russell 2000 by 2% annualized since inception (Dec. 31, 1994.)  This outperformance is persistent through different time periods, bull and bear market cycles, and with less risk.  The performance results of the S&P SmallCap 600 should redefine and raise the bar for passive small-cap beta. 

This is the 2nd part of our blog series containing excerpts from our new paper where we discuss the outperformance of the S&P SmallCap 600 versus the Russell 2000, the performance of the indices compared with active managers, and the case supporting the performance.

THE S&P SMALLCAP 600 OUTPERFORMS THE RUSSELL 2000
Let’s begin with a simple example to demonstrate the long-term outperformance of the S&P SmallCap 600 over the Russell 2000 by showing the cumulative growth of USD 100 from June 1, 1995 to September 29, 2017. The S&P SmallCap 600 would end with a hypothetical value of USD 1,114.38, while the Russell 2000 ends with a hypothetical value of just USD 740.93. Another way to view this is that a market participant would hypothetically return 373% more with the S&P SmallCap 600. Over the period studied, the Russell 1000 slightly outperformed the Russell 2000 and the S&P 500. Since the return of the Russell 1000 was similar to that of the S&P 500, the S&P 500 will be used as the large-cap market benchmark in the analysis. It is also worth noting  that the Russell 1000 includes both large- and mid-cap stocks, whereas the S&P 500 is purely a large-cap index.

Another way to measure S&P SmallCap 600 outperformance is by annualized return and risk, as measured by the standard deviation of returns. Since inception, the S&P SmallCap 600 had an annualized return of 11.6% and annualized risk of 18.3%, generating a Sharpe ratio of 0.50.
Over the same time period, the Russell 2000 had an annualized return of 9.6%, annualized risk of 19.2%, and a Sharpe ratio of 0.37. The S&P SmallCap 600’s returns were higher than the Russell 2000 over every time period analyzed, while its risk was lower in every period.

Since the S&P SmallCap 600 was launched in 1994, there are five bear and bull market cycles (as defined by peak to trough and trough to peak periods of the S&P 500) to analyze, and the S&P SmallCap 600 outperformed the Russell 2000 in four of those cycles. From the beginning of the data set on June 1, 1995, through Sept. 1, 2000, small caps underperformed large caps, but the S&P SmallCap 600 returned 129%, which was 15% more than the Russell 2000. In the following bear market, the S&P SmallCap 600 outperformed the Russell 2000 by 15% again.  Although the next two cycles returned similarly, the S&P SmallCap 600 has been significantly outperforming in the current bull run since the global financial crisis ended in March 2009, beating the Russell 2000 by 66% and the S&P 500 by 108%. These are compelling returns to argue for a strategic allocation to not just small-cap stocks, but to the S&P SmallCap 600 rather than the Russell 2000.

Lastly, the S&P SmallCap 600 had relatively strong monthly and annual returns compared to the Russell 2000. On a monthly average, the Russell 2000 gained 0.89%, slightly more than the 0.83% gain for the S&P 500, but noticeably less than the average monthly return of 1.03% for the S&P SmallCap 600. Perhaps more important is that the S&P SmallCap 600 also provided downside protection. The down market capture ratio for the S&P SmallCap 600 was just 104.8 versus 119.2 for the Russell 2000. This means for every 1% drop in the S&P 500, the Russell 2000 fell an extra 0.2%. Also, the Russell 2000 fell in 45% of months that the S&P 500 fell, which is slightly worse than the 43% rate for the S&P SmallCap 600.

Referring to Exhibit 5, in any given calendar year for the past 23 years, the S&P SmallCap 600 outperformed the Russell 2000 for at least four months. Only in five years did the S&P SmallCap 600 outperform in less than 6 of the 12 months. On average, the S&P SmallCap 600  outperformed by 1.9% per year. The greatest underperformance of 8.9% occurred in 1999 and
the greatest outperformance of 14.8% occurred in 2000.

The performance shown here should at least beg the question of why the S&P SmallCap 600 is not more commonly used as a benchmark. The performance measurement of managers may be held to a higher standard compared with the S&P SmallCap 600. It may bring more credibility to the managers who beat the benchmark, or it could bring to light the managers who might be charging for active management but generating negative alpha.

In the next post of this series, we will show the small cap index performance versus the active small-cap peer group.  The results will show the S&P SmallCap 600 could be considered not just as a benchmark replacement, but rather it could more widely serve as the underlying index for investable passive funds.