Great American Small Cap Scam

[mrWinter]

Anyone care to chime in on whether or not they see wisdom in the arguments made here: "The Great American Small Cap Scam".

Summary:

• Most small cap index funds track the Russel 2000
• The Russell 2000 has very loose criteria for inclusion, unlike the more robust S&P 500 & 600
• Investors can see ahead which companies will be included in the Russell 2000 before the end-of year reshuffling, meaning they can buy before they enter the index, then sell after as all these index funds then buy them up, and sell for profit. We index investors are eating the reciprocal loss.
• There is no profitability screen for inclusion in the Russell 2000, many companies are just losing money hand over fist, have dropped into small-cap territory and are continuing their fall downward and we index investors are investing in them the whole time.
• Consider switching to a committee-based index like the S&P 600 for exposure to the small-cap market.

Some of these points make good sense to me, but perhaps maybe it all boils down to an active vs index argument.


The chart comparing the Russell 2000 with the S&P600 is hard to argue with.

 

[jazz4cash]

It seems to require a paid subscription to get beyond the summary.

 

[COcheesehead]

Just don't buy a small cap index. Buy a managed small cap fund. I've seen studies that show that asset class benefits the most from active management over the long term.

 

[OldShooter]

... I've seen studies that show that asset class benefits the most from active management over the long term.

From the year-end 2017 S&P SPIVA report (https://us.spindices.com/documents/spiva/spiva-us-year-end-2017.pdf?force_download=true), page one:

"... Over the five-year period, 84.23% of large-cap managers, 85.06% of mid-cap managers, and 91.17% of small-cap managers lagged their respective benchmarks. ..."

and

" ... over the 15-year investment horizon, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis. ..."
​

and the companion S&P Manager Persistence reports typically show that outperforming management is basically a random process. So there's no way to identify the outperformers ahead of time.

 

[LOL!]

This is old news, so everybody already knows about it.

So let me ask you this: Which small-cap index funds do YOU own and what indexes do THEY track?

I own IJS small-cap value and it tracks the S&P 600 small-cap value index.
I own VBR small-cap value and it tracks the CRSP US Small Cap Value Index.

I think the reality is that folks just select something that has no-commission at their broker and don't bother with anything else. I don't know what financial salesreps do, but I would not be surprised if they screw their clients. They probably even invented the fake news that COcheesehead wrote about.

 

[indiajust]

I would include low fee structure as well as no commission in that quick decision.

 

[Totoro]

Investors can see ahead which companies will be included in the Russell 2000 before the end-of year reshuffling, meaning they can buy before they enter the index, then sell after as all these index funds then buy them up, and sell for profit. We index investors are eating the reciprocal loss.

Isn't there a mechanism that combats this a little bit? Also, how big is the problem?

There is no profitability screen for inclusion in the Russell 2000, many companies are just losing money hand over fist, have dropped into small-cap territory and are continuing their fall downward and we index investors are investing in them the whole time.

And conversely, small companies shooting up are not in the S&P 500, and some companies make spectacular turnarounds. Amazon made its biggest gains well before it ended up in the S&P 500 I think? A big criticism of the S&P 500 is that overvalued companies tend to end up in there.

Consider switching to a committee-based index like the S&P 600 for exposure to the small-cap market.

Sounds like active management to me.