The past few years have tarnished many of Wall Street's pearls of wisdom: Buy on the dips. The trend is your friend. Tech stocks aren't cyclical. Now, it's time to call into question another one--that actively managed mutual funds trump index funds when it comes to small-cap stocks.
For years, pros have argued that smaller companies are little followed and that their shares are often mispriced. So savvy investors should find bargains among them. But a recent study by Standard & Poor's (like BusinessWeek, a unit of The McGraw-Hill Companies) (MHP
)challenges that notion. It found that only a third of small-cap fund managers beat the S&P SmallCap 600 Index during the five years ended Sept. 30, while 37% of large-cap funds beat the Standard & Poor's 500-stock index.
The study matters because it takes into account the performance of funds that were liquidated due to poor performance or too few assets. Without this adjustment, the results would have been skewed in favor of actively managed funds by "survivorship bias." In the past five years--a period of manic market highs and lows--16% of domestic equity funds disappeared. Many studies have failed to account for this bias.
Why did so many small-cap funds trail the index? Higher costs. "If an index is constructed properly, active managers should lag it after costs, regardless of whether the index tracks small-, mid-, or large-caps," says Gus Sauter, chief of Vanguard Group's equity index funds. In the small-cap arena, those costs are steep. The average annual expense ratio for small-cap funds is 1.58% of assets, vs. 1.36% for large-cap funds and about 0.3% for index funds. Small-cap funds also incur higher transaction costs when they trade illiquid securities. Sauter says such costs are at least 1.5% of assets for active small-cap funds.
Some managers argue that stocks in small-cap indexes aren't representative of managers' holdings. For starters, the S&P index doesn't have the initial public offerings these managers often buy. What's more, "the average small-cap fund owns stocks that have a higher market capitalization than the average stock in small-cap indexes," says Morty Schaja, president of Baron Funds, which manages $3 billion. "In recent years, the smallest stocks have performed better." True, but managers could always buy those smaller stocks and shun IPOs.
The Moral: If you like index investing, try small-cap index funds as well as large. If you don't, concede that you may have as much trouble beating indexes as managers do.
Personal Finance Editor Braham writes about mutual funds.
Get BusinessWeek directly on your desktop with our RSS feeds.
Add BusinessWeek news to your Web site with our headline feed.
Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video.
To subscribe online to BusinessWeek magazine, please click here.
Copyright 2003, by The McGraw-Hill Companies Inc. All rights reserved.
Printer-Friendly Version
