Suppose you were a financial advisor during the height of the financial crisis in the first quarter of 2009, and you presciently theorized that the market was bottoming as Federal Reserve policies and emergency U.S. Treasury rescue programs took hold to reestablish confidence in capital markets. Your theory was to favor small-cap stocks because you believed massive monetary stimulus would result in strong fundamental growth and multiple expansions for this group. The challenging question you would have next faced is how to implement your investment thesis for clients. One significant issue is whether you would have invested client capital in actively managed or passively managed funds.
Inspired by the S&P Persistence Scorecard, I simulated this scenario in preparation for a recent S&P Dow Jones webinar, “For the Love of U.S. Small-Caps”, and I analyzed what the results would have been for the clients of such a financial advisor.
Crucially, our financial advisor from early 2009 – with the extremely timely and rare insight to seek small-cap exposure at that particular point in time – could have easily fallen victim to the all-too common misconception that it pays to seek active managers in “less efficient” segments like small-cap. As shown in the chart below, he or she might have cost their clients significant wealth in the form of lost opportunity – particularly since their investment thesis turned out to be so prescient.
On the other hand, had he or she resisted the “sophisticated” idea that relatively inefficient markets make fertile ground for alpha generation and stuck with a low cost index fund, they would have captured the handsome small-cap returns we have seen over the last few years. Only one further distinction would have created additional value for his or her clients – the selection of the small-cap benchmark used to capture the market return. Had an index fund tracking the S&P SmallCap 600 instead of the Russell 2000 been selected, clients would have been about 23% richer.