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Actively Managed Small-Cap Funds Have an Edge - Royce Funds Commentary

June 10, 2013 | About:
Holly LaFon

Holly LaFon

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Although 10-year Treasury rates rose last month, the strong performance of certain cyclical sectors within small-cap looks to us like investors may be showing a bit more confidence in areas favored by many active investment approaches.No matter how one looks at the market for the month of May 2013, this much is clear—it was different. The trail left by bond investors moving out of the equity markets over the past several years, which has stretched absolute valuations in some of the most defensive areas of the market, was a bit harder to trace as 10-year Treasury rates rose 50 basis points during the month.

Interest rate sensitive sectors, such as real estate investment trusts (REITs) and utilities declined 6.2% and 3.3%, respectively, for the month according to research published by Bank of America/Merrill Lynch.

Interestingly, cyclical sectors dramatically outperformed their defensive peers for the month as investors focused more on real economic growth, with the Technology and Consumer Discretionary sectors leading the way. Year-to-date, through the end of May, the Russell 2000 Index gained 16.5% and for the one-year period, advancing 31.1%.

As we have mentioned before, the last few years have been incredibly difficult for active managers, and there is no shortage of evidence that the number of outperforming active managers across all equity asset classes may have reached long-term lows.

Active managers such as ourselves have been stymied by the perplexing market dynamic whereby defensive sectors such as Consumer Staples, Health Care, Utilities, and Real Estate Investment Trusts have been leading in a strongly rallying tape.

Considering the market’s recently inhospitable behavior, we have often been asked if we have been tempted to abandon our quality-centric active approach. Now, however, it seems to us that the relevant question is, “Are active managers finally about to assert themselves relative to their passive counterparts?”

The answer may lie in understanding the Russell 2000 Index, which quickly gained acceptance as a small-cap benchmark following its inception on December 31, 1978. The index measures the performance of the 2,000 smallest companies in the Russell 3000 Index (which represents 99% of the U.S. equity market) and represents approximately 8% of the total market capitalization of the larger Russell index.

Inclusion is objective in nature, as no committee determines membership. Russell Investment Group stresses the need to accurately represent the market as it is. As such, market cap is more important than valuation risk, sustainability, and even profitability.

In a recent research report, Jim Furey of Furey Research Partners explains that “an investor buying a Russell 2000 Index ETF had better be prepared to plunk down cash in return for a fund that allocates 27% of its assets to loss-making companies and is trading at 43x last twelve month earnings.

To our mind, it makes no sense for institutions to assume small-cap exposure through a passive index rather than allocating resources to managers with track records of capital preservation and long-term benchmark outperformance.”

To be sure, one month does not make a trend. However, we contend that the current environment argues for a more active and disciplined approach, one driven by fundamentally sound companies selling at attractive valuations.

It is important to note that we view an index or benchmark as a point of reference that provides shareholders, potential investors, and us with a representative return for a broad-based asset class.

Unlike a lot of investment managers, we do not manage against a particular index and we think of ourselves as benchmark agnostic. In other words, we select companies for our portfolios because we believe that they can provide a desired rate of return, not because we think they can beat the return provided by a particular index.

Our Funds are built stock by stock by employing a business buyer’s approach to investing that takes into consideration quantitative and qualitative factors. We do not begin the investment process with an eye toward replicating a benchmark. Rather, we look for well-run companies with histories of high returns on invested capital that are trading at discounted prices.

To that end, there is tremendous earnings power to be unlocked in many of our portfolio holdings. As the U.S. economy continues to recover and drives sales growth at these companies, we believe the inherent operating leverage in their respective business models will propel earnings.

As we have seen in the market of late, improving fundamentals can still attract investors, which in turn should drive valuations for our companies. This is how our contrarian investment approach has worked in the past, and while taking longer than we would have expected, we do not believe there are any structural reasons why this pattern should not repeat itself going forward.

Stay tuned…

FDG

Important Disclosure Information

Francis Gannon is a portfolio manager of Royce & Associates, LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.


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