Active Management

3 Reasons To Be Optimistic About Active Management

Senior Investment Strategist Steve Lipper examines a small-cap market transitioning to one that looks more favorable for active management.

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Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?

Describe the transitions you’re seeing in the small-cap market.

We here at Royce think there are three transitions going on in the small-cap market. All of which have historically had meaningful effects on small-cap active outperformance. The first is volatility. During most environments in below-average, average and above-average volatility regimes, active small-cap has beaten the benchmark, if we use a rolling five-year period as our measurement.

Better Active Outperformance in Normal Volatility Periods
Batting Average for 5-Year Monthly Rolling Periods by Standard Deviation Ranges from 12/31/78 through 3/31/18

Active Management

“Active” represented by Morningstar’s U.S. Small Blend Category. There were 542 U.S. Small Blend Funds tracked by Morningstar with at least five years of performance history as of 3/31/18.
Standard deviation is a statistical measure within which a fund’s total returns have varied over time. The greater the standard deviation, the greater a fund’s volatility.

The only time it really hasn’t the majority of time, has been very low volatility. That's relevant for two reasons: the first is, we’ve just ended among the lowest volatility regimes that we have seen. And the second is, as we have experienced in Q1, we think that's over. That we are transitioning to a more normal, which is to say higher, volatility environment. And what’s helpful to know is historically, those have been periods that have been better for active performance.

How does small-cap style leadership affect active management?

Style leadership has also had an effect on the success of active versus passive and small-cap. So looking at rolling five-year periods, active has beaten passive over 60 of the time in all environments. But there is a striking difference in value versus growth-led leadership. In a value leadership environment, active has beaten passive over 80% of the time.

Percentage Small-Cap Active Beat Russell 2000
5-Year Monthly Rolling Returns from 12/31/78 through 3/31/18

Active Management

Active Management

“Active” represented by Morningstar’s U.S. Small Blend Category. There were 542 U.S. Small Blend Funds tracked by Morningstar with at least five years of performance history as of 3/31/18.

How do different return environments affect active management?

So the other subtlety about market environment and how it intersects with the opportunities for active is higher return environments and lower return environments. Double-digit return environments that we’ve just been through have historically been more difficult for active managers. They've either outperformed by less, or actually underperformed.

Small-Cap Active Historically Has Done Better in Single Digit Return Years
Monthly Rolling 5-Year U.S. Small Blend Average Excess Returns During Russell 2000 Return Ranges From 12/31/78 through 3/31/18

Active Management

There were 542 U.S. Fund Small Blend Funds tracked by Morningstar with at least five years of performance history as of 3/31/18.
The excess return for a Morningstar category would be the category’s return for the period minus the Index return.

Single-digit return environments, in fact more specifically high single-digit, between five and ten percent have been those where the average spread of the active manager versus the Russell Index has been the largest. The consequence is if we’re right on our expectations here at Royce that we’re headed for a period of more normal volatility, which is to say higher, and if we’re shifting the style of leadership towards value, and if our expectations going forward that the market return is going to be single-digit, it may be useful to know that all three of those historically have been very supportive for active small-caps.

Article by The Royce Funds

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