Oranges and Apple

Measuring Active Small Cap Manager Performance: Why benchmarks matter

Oranges and Apple


While index investing is generally accepted as a successful long-term strategy for large cap investing, it is still a common belief that active managers can beat small cap index benchmarks. This misconception is due to the perceived opportunity to add value through active management created by the apparent inefficiencies associated with small caps. In fact, independent research and data shows that it is benchmark selection that perpetuates this misperception and, just like large caps, small caps offer excellent index investing strategies.

Measuring Performance

Ennis and Sebastian (1) [2002] list evaluation errors such as the use of an inappropriate benchmark and survivorship bias effects as two reasons for the perceived "small-cap alpha myth." So, while manager skill can add value and produce superior results over the benchmark, data does not support the notion that active managers will consistently beat an appropriate benchmark.

This conclusion is supported by a study of the performance returns (net of management fees) of U.S. domiciled mutual funds classified as "small cap blend" in existence as of May 31, 2002 and found in the Standard & Poor's Advisor Services database which covers over 14,000 U.S. mutual funds in total.

As noted by Ennis and Sebastian, most studies suffer from survivorship bias. This study is no different. Only those mutual funds in existence today were used to rank performance back in 1995. Survivorship effects create an upward bias on mutual fund performance because discontinued funds are not included in the analysis. With this in mind, the results in Figure 1 still show that a high proportion of mutual fund managers are not beating the small cap benchmark.

Furthermore, this analysis shows that the choice of benchmark against which managers are evaluated makes a serious difference in performance measurement. Since 1995, results show that apart from the technology boom of 1999, the median active small cap manager has out performed the Russell 2000 benchmark. However when measured against the S&P SmallCap 600, the median manager in all years except 1999 has matched or under performed the benchmark.

The Performance Differential

Historically, the S&P SmallCap 600 and Russell 2000 small cap index have had considerably different performance patterns. Since 1995, the S&P SmallCap 600 has cumulatively outperformed the Russell 2000 by over 25%. Therefore, it is important to consider which benchmark active fund managers are being compared against when evaluating returns.

Much of this performance differential is due to index methodology and maintenance. An Index Committee, whose objective is to reflect the small cap characteristics of the universe at all times, manages the S&P SmallCap 600. The index is maintained throughout the year with additions and deletions taking place as needed. New additions are selected based on the following general criteria:

  • Sector representation, to reflect the sector weightings of the small cap universe;
  • Market capitalization, between approximately $250 million to $1 billion;
  • Liquidity and float, to ensure investability and portfolio efficiency; and,
  • Financial viability, to ensure that the company appears to be a "going concern," i.e. the company has reported four consecutive quarters of positive earnings.

In fact, it is this profitability screen that Rattray (2) [April 2002] found to explain a majority of the performance differential.

In contrast, the Russell 2000 index is reconstituted once a year and not maintained again until the following year. Stocks are ranked from largest to smallest on May 31st of each year. The largest 1000 companies constitute the Russell 1000 and those ranked no. 1001 to 3000 become the new Russell 2000 index for the year.

Budny (3) [May 2002] describes the Russell 2000 index reconstitution as selling its small cap winners to the Russell 1000 and buying large cap losers from the Russell 1000. Furey (4) [December 2001] agrees, saying the S&P SmallCap 600 has outperformed because the Russell 2000 index possesses an inherent "loser bias" not present in the S&P SmallCap 600.

The largest performance differential took place in 1999 and 2000. This is largely a result of the tech boom/IPO phenomenon and the treatment of such stocks under the different methodologies outlined above. Because of the Committee's profitability and earnings screens, the S&P SmallCap 600 was relatively protected from the demise of the tech sector.


Independent research shows that choice of benchmark significantly affects whether an active small cap fund manager adds value beyond the benchmark. Historically, data has shown that large cap funds under perform their benchmarks over the long term. The data and research demonstrate that the same is true for the majority of small cap funds. As Jankovskis (5) [2002] points out, changing to a more demanding benchmark would "raise the bar" for small cap managers and challenge the assertion that active management is better suited for small cap stocks than large caps.

Analysis of the difference in methodology and the performance results of the two small cap indices makes it clear that using the S&P SmallCap 600 as a benchmark resolves the inefficiencies assumed to be associated with small caps and provides a better gauge for evaluating active manager performance.

The S&P SmallCap 600 raises the hurdle for performance measurement. Historical results show that fewer active managers have been able to beat the S&P SmallCap 600. Passive management is widely accepted for large caps. A change in benchmark could lead to a similar conclusion for small caps.


1. Ennis, Richard M., and Sebastian, Michael D. "The Small-Cap Alpha Myth." The Journal of Portfolio Management, Spring 2002, pp. 11-16.
2. Rattray, Sandy et al., "Equity Indexes/Quantitative Insights." Goldman Sachs, April 11, 2002
3. Budny, Alex E., "Small-Cap Benchmarks: Why are They So Different?" The Outlook, Lehman Brothers, May 13, 2002, pp 11-13
4. Furey, James H., "Russell 2000 Bigger but Not Better Benchmark." Pensions & Investments, December 10, 2001
5. Jankovskis, Peter, "The Not So Perfect Index. The Impact of Russell 2000 Rebalancing on Small-Cap Performance." The Journal of Indexes Magazine, Second Quarter 2002


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