McLean Heuristics

For the year to date, Value and Small Capitalization company categories are underperforming Growth and Large Company stocks. So why do we believe in tilting portfolios toward Value and Small stocks, more so than most other advisors and wealth managers we see? Because we believe, and the data illustrates, that markets price securities in a way that compensates investors with additional return for that added risk.

It is important that we set expectations with our clients that small/value investing carries risk and that our portfolios will in fact have periods of underperformance. We expect this result from the risk and return relationship. If small company and value stocks always beat the market, then there would be no risk to the investor. While there will be periods of underperformance, over
the long run we expect that markets reward investors for taking on this additional risk. If this were not the case, then why would anyone invest in a riskier micro cap name, when they could simply buy Microsoft?  A review of intermediate to long term results shows us why.

Attached is a recently developed illustration showing the percentage of rolling time periods where value-oriented companies outperformed growth-oriented companies; and where small company equities beat large companies.  The analysis is presented for both US and International equities. Please note that we have never suggested portfolios be constructed to take outsized risks in any category. No matter the argument you can make for overweighting a category, you can be very wrong with that strategy over short periods of time. The extent of how wrong may cause a loss of faith in a strategy just when it may be poised for a recovery. Just as some were tempted to (and actually did) eschew international, value and small company stocks in the late 1990s, it is too
early to declare US large company growth stocks permanently dead as a category.  In spite of their extended underperformance through this past decade, history tells us that the future may be different for this sector. Right now, it may appear that gold is going to keep going up in price, that Apple just can’t lose given their future prospects, that interest rates have to go up, that real
estate is a poor investment and that Obama won’t win reelection, betting the farm on any of those events is not prudent.

Diversification with a tilt to International, Value and Small company stocks may increase short term volatility, but has historically produced stronger long term results. We believe that will continue to be the case.

MAMC’s Risk Analysis-Small Cap and Value Dimensions

The debate over market efficiency may never be settled. But no one can argue the historical returns evidence, which shows that active management does not pay for itself, in aggregate.

The efficient markets hypothesis implies that no active investor will consistently beat the market over long periods of time, except by chance. Yet active managers test the hypothesis every day through their efforts to pick stocks and time markets. The evidence shows that their efforts are not worth the high cost borne by investors.

The first chart displays the percentage of actively managed public equity funds that failed to outperform their respective market benchmarks for each major fund category for the five-year period ending June 2011. Most of the fund categories failed to beat their respective benchmark as a group. This is consistent with research, which shows that, as a group, active managers underperform the market by an amount equivalent to their average fees and expenses. 

The lone exception is the international small fund manager category during the period. As indicated in the graph, 24% of this group failed to beat the respective benchmark, which is the S&P Developed ex-US Small Cap index. More detailed analysis reveals that many managers in the international small category had significant holdings in emerging market stocks, which is a different asset class that had stronger performance during the period. The large percentage of outperformance among international small managers may result from a large portion of them holding a different asset class and being compared to the wrong benchmark.

If the manager group’s average return is benchmarked to an international small cap index that includes emerging markets, the rate of underperformance rises to over 60%, which is in line with the other equity fund categories. (Benchmark is the MSCI All Country World ex USA Small Cap Index.)

Research by Eugene Fama and other financial academics has offered evidence that the bond markets likewise are efficient and that interest rates and bond prices do not move predictably. This appears to be the case with all types of issues, from short-term government instruments to long-term corporate bonds.

The second slide illustrates the formidable challenge that active bond managers face. The graph shows the percentage of active fixed income funds in each category that failed to beat their respective market benchmark for the five-year period ending June 2011. All categories had at least a 56% failure rate, with failure defined as underperforming their benchmark.

The last two charts show actively managed mutual funds that achieve top performance in one period typically do not repeat their success in a subsequent period.

The stacked graph at left sorts the entire US equity fund universe (Page 1) and US fixed income universe (Page 2) by cumulative 5-year performance relative to each fund’s benchmark (includes only those funds with a complete return history for the period). The right box shows how these top-quartile funds performed relative to their benchmarks in the subsequent five-year period. The arrows indicate the movement of these top funds across quartiles.

GRAPHS -Failure of Actively Managed Mutual Funds

The lesson of these illustrations: choosing actively managed equity funds according to past success does not guarantee an equally successful investment outcome in the future. This is consistent with financial theory and research, which propose that active managers cannot outperform the market as a group, particularly after accounting for management fees, trading costs, and other expenses.