Forget Managed Funds — Pick Your Own Small-Cap Stocks

by James Brumley | January 28, 2013 6:30 am

It’s no big secret that, historically, most mutual funds under-perform their benchmark index like the S&P 500 or the equivalent S&P 500 ETF (NYSE:SPY[1]). Although the relative results vary a little every year, on average, anywhere between 65% and 80% of large-cap mutual fund managers can’t beat the market in any given year.

Well-versed and experienced long-term investors also know, however, that the performance lag is most often seen within the large-cap segment of the stock market. Funds that focus on picking small- or mid-cap stocks[2] are actually apt to beat their respective benchmarks — the S&P 600 Small Cap Index and the S&P 400 Mid Cap Index — in any particular year.

Why? Because it’s easier for a smart fund manager to find an edge (or uncover new information) in the relatively under-studied arena of small caps and mid caps. Historically, around half of small and mid cap fund managers were able to top their respective indices most years. That’s pretty good, by market standards.

Unfortunately, the edge that small-cap fund gurus have enjoyed for so long is starting to deteriorate.

Numbers Don’t Lie

This sub-par performance has been happening for more than a couple of years. Near the end of last year, Standard & Poor’s reported that 77% of small cap funds had lagged compared to the S&P 600 over a five-year period, while more than 80% of mid-cap mutual fund managers couldn’t beat their S&P 400 benchmark for the past few years.

Granted, that time-frame included a pretty nasty bear market. But that shouldn’t matter; the people managing this money are professionals and are paid to know when to get in, when to get out and which stocks to buy or sell.

Worse, even the few funds from any market cap group that manage to beat their benchmark in any given year generally fail to do so the next year. So, finding a ‘hot’ fund is more than a little pointless.

But Numbers Do Mislead

Still, while the broad statistics paint a discouraging picture, there’s more to the story.

Though most fund managers lag their benchmarks, some deep research suggests that they’re not all bad stock-pickers. Instead, the fund company they work for may encourage over-diversification. The mutual fund industry’s all-stars are usually the ones that have a more focused (AKA less diversified) portfolio holding only a handful of trades that manager has an enormous amount of confidence in. Morningstar’s Samuel Lee has the scoop[3] on the idea.

It’s not an approach that is risk-free mind you, and when it’s all said and done, a more concentrated portfolio WILL be a more volatile portfolio. Plus, it presumes you’re at least a better-than-average stock picker … and that can be a problem as well. A second reason so many funds lag their benchmarks is — no surprise here — overconfidence from a fund’s manager and/or management team.

At the very least, fund managers are pedigreed with an MBA or a CFA, and occasionally, they’re even a PhD. That high-profile education allegedly equips them with the tools and knowledge needed to pick stocks better than amateurs can.

In reality, the market doesn’t care about all the theoretical jargon or economic formulas or “the way things are supposed to be.” In other words, many fund managers keep applying rational strategies to an irrational market. Instead, like their successful amateur counterparts, successful fund managers must be willing to act on what the market is doing rather than what they think it should be doing. Some do, but most can’t.

Plus, fund managers struggle with the same induced biases that any other investor deals with — not because they’re not smart, but because they’re human.

Famed investor Jeremy Grantham hits the nail right on the head by writing:

“The central truth of the investment business is that investment behavior is driven by career risk. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority ‘go with the flow,’ either completely or partially. Missing a big move, however unjustified it may be by fundamentals, is to take a very high risk of being fired.”

Said another way, too many of the institutional guys and gals are reading the same news articles you are, and chasing the same stocks. You’re better off looking for companies that aren’t making daily headlines.

The Bottom Line

In the end, it’s still easier to pick undiscovered gems from the market’s small- and mid-cap names, while it still remains near-impossible to beat the large-cap market by picking large-cap stocks. So if you’re willing and able, just own a large-cap index fund or ETF to fill up the large-cap portion of your allocation, but use individual picks to fill out the small- and mid-cap portions of your portfolio.

This may feel counter-intuitive, and may well be the opposite of the approach you’ve been taught. But bear in mind the financial industry that taught you how to invest is the same industry that usually can’t beat the market itself.

And remember: Your edge with small caps and mid caps doesn’t hinge on knowing more about a company than the rest of the market. Why? Because the odds are, in this day and age of digital communication where instant information transmission is the norm, there’s always someone who knows more than you.

Instead, your edge in owning smaller equities lies in your ability to handle them in a disciplined manner and pinpointing the right entry and exit point. In fact, sticking with the off-the-radar names that are quietly leading the way actually helps — even if it feels a little uncomfortable to do so at times.

As of this writing, James Brumley did not own a position in any of the aforementioned securities.

  1. SPY:
  2. Funds that focus on picking small- or mid-cap stocks:
  3. has the scoop:

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