The Small Cap Alpha Myth


by Melissa Johnson Saturday, September 01, 2001

Many people are led to believe that active managers can provide a greater advantage and higher value to investors in the small-cap versus large-cap market, thus resulting in a larger alpha. A large alpha infers that the stock or mutual fund has performed better than would be expected based on its volatility or risk, suggesting that active management is the reason for the better than expected performance.

Richard M. Ennis and Michael D. Sebastian constructed a sample of 128 products from the Mobius Group M-Search database, a small-cap database of institutional commingled funds and composites of separate accounts. They concluded that this so-called small-cap-alpha advantage is actually the "small-cap-alpha myth." At first view, it appears that a small-cap alpha advantage does exist. When looking at the ten-year period ending June 30, 2001, their research showed that the median portfolio in their sample outperformed the Russell 2000 Index by 4.04%. But a more accurate picture formed when they delved deeper.

When three important performance evaluation methods were considered, the alpha diminished to virtually zero. These performance evaluation errors include 1) neglecting to account for management fees, 2) comparing the portfolio to an inappropriate benchmark, and 3) overlooking survivorship bias.

Error #1
Ninety percent of the products in the sample reported performance gross of fees. When fees were included in the equation, the net alpha dropped from 4.04% to 3.09%.

Error #2
To derive an accurate net return, appropriate benchmarks must be used for comparison. A single index, such as the Russell 2000, cannot be used for proper comparison if the portfolios being compared are not exactly the same in style and make-up as that index. Ennis and Sebastian created effective style mixes (ESMs) for the products being studied. Based on a type of multiple regression, ESMs are a more precise way to benchmark. Now accounting for errors #1 and #2, the net alpha dropped from 4.04% to 1.2%.

Error #3
Many databases do not include the records of products that no longer survive, which hyperinflates the performance reports of active managers and funds. This is called Survivorship Bias and does not accurately reflect true performance.

When considering all three performance evaluation errors, Ennis and Sebastian concluded that the true median alpha in their sample is "likely to be zero or negative, not 4%." They summarized that there is "no support for the claim that active management of small-cap portfolios is any more fruitful than it is for large-cap portfolios." In other words, forget about it! Focus on the only important question of investing: "what asset allocation of index funds is most appropriate for you?"

Source: "The Small-Cap-Alpha Myth", Richard M. Ennis, CFA; Michael D. Sebastian, Ennis Knupp + Associates, September 2001 (www.ennisknupp.com).

Richard M. Ennis, CFA, is founder, principal, and consultant for Ennis, Knupp & Associates. Prior to joining Ennis, Knupp & Associates, he was affiliated with A.G. Becker, O'Brien (now Wilshire) Associates and Transamerica Investment Management. Mr. Ennis is the author of numerous articles, coauthor of Spending Policy for Educational Endowments, and a recipient of a Financial Analysts Journal Graham and Dodd award. Mr. Ennis holds a B.S. from California State University at Northridge and an M.B.A. from the University of California at Los Angeles.
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