Grandeur Peak Global Advisors, LLC

The Limitations of Passive Investing Over the past decade, more and more investors have utilized index funds to gain public equity market exposure. In the US market, approximately 75% of assets invested in US Large Cap Blend strategies benchmarked against the S&P 500 are in index funds. When you look at the past 5- and 10-year returns, there is little wonder why this is the case. As exhibit 1 illustrates, S&P 500 index funds, on average, have outperformed their actively managed counterparts meaningfully. Furthermore, passive funds have achieved this while tracking their benchmark’s return with minimal variation (i.e., tracking error**). However, in equity markets outside the US and/or down the market cap spectrum, passive investing is much less compelling. For example, within foreign large cap equity strategies, 43% of assets are invested passively today, a far lower percentage than what is observed in the US large cap market. This is for good reason. On average, passively managed foreign large cap funds have performed in-line with actively managed funds over 5 and 10 years, but realized significantly higher tracking error than passive US large cap funds. See exhibit 2. In foreign small cap markets, passive investing makes even less sense, which is why only 17% of assets invested in the space do so passively. As illustrated in exhibit 3, on average, passive foreign small cap funds have underperformed active managers over the past 5 and 10 years. Also, like foreign large caps, foreign small cap index funds have failed to track their index within a range that most would assume reasonable to be considered as an “index” fund. The strong outperformance of active foreign small cap funds versus passive funds over the past 5 and 10 years isn’t coincidental. In fact, the case to invest actively within foreign small cap markets becomes even more convincing as we look back over time. As illustrated in exhibit 4, over rolling 5- and 10-year periods, the average excess return realized by active funds over passive funds is typically even higher. Over time, active funds outperform passive funds by +1.28% and +1.61% on average over rolling 5- and 10-year periods, respectively. So, one might conclude that we may be at a low point in the active vs. passive cycle and that active’s outperformance over passive stands to improve when market conditions that have disrupted small cap markets over the past 3 years begin to normalize.   This post is for information and educational purposes only and expresses our opinion and view of the market, and is not a recommendation to transact in any securities. **Tracking error definition in Comment section

Grandeur Peak will be participating in a VettaFi webcast on November 18th at 2pm ET. Come listen to Mark Madsen speak on the topic of Hidden Gems in Small Cap Investing with Todd Rosenbluth, Head of Research at VettaFi. CE credit available. Please use the link below to register. https://lnkd.in/gSQiUzWy VettaFi Todd Rosenbluth

A Grandeur View: What’s Driving Recent Performance in the Small Cap Market? -        While we see earnings growth as the dominant long-term driver of equity market price performance, earnings don’t seem to be driving small cap markets over the past three years. -        Instead, small cap markets have had an uncommonly high correlation with interest rates, especially US interest rates. -        The 3-year correlation of US small caps to US core bond prices is 0.61 and, remarkably, even higher for foreign small cap growth stocks at 0.96. -        In contrast, the 3-year correlation of the S&P 500 to US core bond prices is meaningfully lower at 0.19. -        Investors seem to believe that small cap stocks stand to lose/benefit more from restrictive/accommodative US monetary policies than larger cap stocks. Paradoxically, this is more so the case with foreign small caps. -        The last two months of 2023 reinforced the current strength of the small cap stock – US bond relationship. During the period, weaker inflation and economic data prompted the market to increase the number of expected 2024 rate cuts by the Fed from three to seven. The 10-year US Treasury yield fell by 1% to 3.9% over the same period. In response, global small cap stocks, as measured by the MSCI ACWI Small Cap Index, increased +19.2%, outperforming the S&P 500 by 5.1%. -        Then in Q1 ’24, inflation as measured by the Consumer Price Index (CPI) surprised to the upside in each of the three months, driving interest rates higher and significantly reducing expected 2024 Fed rate cuts. -        This reversal seemed to influence small cap price momentum to stall and give back the outperformance realized versus US large cap stocks in late 2023. -        It is unclear how long the strong relationship between small cap stocks and interest rates will persist. Eventually we expect fundamental earnings growth to resume its position as the primary determinant of small cap equity market price performance. 

As public market small cap investors, we frequently observe companies we follow or invest in being acquired by private equity buyers. Conversely, we will at times participate in initial public offerings of companies previously owned by private equity investors. While access to private markets is much more limited than public small cap, we believe these two markets offer very similar actual investment exposure. One of the arguments for investing in both private equity and small cap public equity is that these are less efficiently priced markets. We believe the scales have tipped in recent years to make small cap public equity a more inefficient market than private equity. The flows of capital out of global small/mid cap and into private equity are both at all-time highs. Where do you think the greatest market inefficiencies are?

A Grandeur View: A Case for Small Cap Stocks While it is impossible to forecast public equity market returns, history has shown that long-term performance is potentially driven by earnings growth. The price-earnings correlation of the S&P 500 index dating back to 1957 is 0.97 (see first chart). This price-earnings relationship is similar across other public equity markets, including small caps. Historically, smaller companies have shown they can potentially grow earnings at a higher rate than larger companies (see second chart). While small cap stocks can potentially offer investors the prospect of higher earnings growth, and the price returns that follow, small cap stocks are not for the faint of heart. By their nature, they are less liquid than large cap stocks and can also exhibit more volatility. However, we believe that disciplined and patient small cap investors have the opportunity to capture the attractive earnings growth, and returns, of smaller companies in the long run.