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Colleen White
Client Analytics
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Industry Analysis

Is Hedge Fund Alpha in Small Cap Stocks a Myth?

Intuitively, alpha should live in smaller market cap buckets. Why is it so challenging to generate alpha with them then?

Small Caps Should be Ripe for Alpha

As we have shown in prior research, the hedge fund universe is actively moving up the market capitalization spectrum, while intuition suggests that alpha should reside in smaller market cap stocks. These names get less media and analyst coverage offering hedge fund managers the opportunity to capitalize on this knowledge asymmetry. To test this, we used the Novus Framework to analyze alpha by market cap bucket for our Hedge Fund Universe over the past decade. Surprisingly, micro cap names held by our Hedge Fund Universe have never generated alpha, and small caps have done so only once, in 2009. On the other hand, alpha has been consistently concentrated in the mega and large cap names. Below is a chart of alpha by market cap bucket generated by our list of hedge fund managers over the last decade:

hedge fund alpha small cap stocks

Why is it so challenging to generate alpha in smaller market cap buckets? We came up with the following working theories:

1. Skilled small cap stock pickers don’t necessarily meet the regulatory capital threshold of $100 million in AUM, and thus do not show up in our Hedge Fund Universe (HFU) on which the study is based.

If this is the case, the road ends here as we are limited to public data made available through SEC filings. However, this can’t explain away the market cap alpha question, as there are many skilled midsize managers with strong track records who are able to invest in smaller cap names more freely than large managers.

Considering absolute performance across market caps, we find that consistently picking winning names in smaller buckets has proved challenging. The chart below shows that mega and large cap buckets have boasted a Win/Loss ratio of 3.90 and 4.20, meaning the average winner made 3.9x and 4.2x that of the average loser, respectively (2005-2015). Small and micro cap buckets have Win/Loss ratios of less than one; losers lose more than winners win.

hedge fund alpha small cap stocks

So far in 2015, there have been a few outsized alpha generators and detractors, with most names belonging in large or mega cap buckets.

hedge fund alpha small cap stocks

hedge fund alpha small cap stocks

The story is similar if we look over the past 10 years.

hedge fund alpha small cap stocks

hedge fund alpha small cap stocks

The prevalence of large cap names among historical top performers and detractors suggest that dispersion may play a role. Our next theory will explore this.

2. There is more dispersion in large cap names than small cap names.

In a research paper, we argued that high dispersion, low correlation environments are most fertile for alpha generation. We’d be interested to analyze this phenomenon across market caps. If dispersion is greater for large and mega cap names, this would suggest they provide an opportunity set for investors to capture outperformance.

3. Size mitigates risk—and protects alpha.

The potential downside and potential upside is greater for smaller market cap names. These companies generally are less well-known, have a shorter track record, and are generally more susceptible to extreme price movements their larger market cap counterparts. Smaller cap names have a greater risk of hitting rock bottom than large cap names as they have shorter to fall. Conversely, small cap names can also generate astronomical returns. We hypothesize that the worst performing small cap names destroy the alpha generated on the over-performing names in the same bucket. In mega cap names, we suspect there to be a slightly heavier right tail, which insulates mega and large cap alpha. To test this, we will remove the tail end performers and perform the same analysis.

Conclusion

The weighted average market capitalization for our HFU is near record highs. As hedge funds continue to gravitate out of the smaller cap names, understanding how and why funds overperform and underperform across market caps and within market regimes is crucial to the investment process. In future posts, we will unpack the apparent dearth of alpha in smaller market cap names and abundance of alpha in large caps.


 

Top Hedge Fund Stock-Pickers Report

The Q1 2015 Novus Top Hedge Fund Stock-Pickers Report highlights the most skilled stock-pickers within each sector. Only available through Novus, this exclusive report is the only ranking of Hedge Funds managers by historical stock-picking success.

Included in the report are the positions, sector allocations, and simulated historical performance of these top funds.

Download this exclusive report now.

This exclusive report includes:

  • THE TOP 10 STOCK-PICKERS IN EACH SECTOR
  • POSITION CHANGE REPORTS FOR THE NO. 1 PICKER IN EACH SECTOR
  • 3-YEAR SECTOR SECURITY SELECTION AND WIN/LOSS RATIOS

top hedge fund stock pickers

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