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Portfolio Strategy

Why (Most) Hedge Funds Should Avoid Small Caps

While the majority of hedge funds underperform across all small cap sectors, a few have managed to create alpha.

Melina Sanchez
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There is a common stereotype in the financial world around the outperformance of small caps. While newly born hedge funds are said to prefer small caps, many allocators seek to find the best small cap-focused managers because of the supposed high return potential. Nonetheless, as we have previously shown, both conventions are wrong: smaller shops don’t invest in smaller companies than multi-billion hedge funds, nor do small caps necessarily bring higher alpha for the hedge fund universe.

This article aims to slice and dice small-cap alpha through multiple lenses: provided that hedge funds have lost more money from small caps that from other market cap companies, do they continuously detract alpha across all sectors in small caps? Are there specific sectors that managers may want to avoid in the small cap spectrum?

About our Data

Everything mentioned in this post is sourced exclusively from public regulatory data, including simulated performance and all other analysis and commentary. The data used here omits the short side, non-equity securities, many non-US securities and all non-public information.

Small Cap Alpha Analysis

We have written before about the myth of small cap alpha. Subject to the assumptions and limitations of public data, we came to the conclusion that 1. Small caps generate less alpha on average than all other market caps and 2. Small cap alpha has actually been negative in the last decade.

Based on our Hedge Fund Universe database, we can further our analyses and apply filters to small cap names. In this article, we decided to look at alpha generation by sector within the small cap spectrum. The results are as striking as those of our previous research pieces: HFU managers have detracted alpha from all small-cap sectors they were invested in the last decade. The biggest losers have been information technology, energy, and industrials.

small cap alpha

All the above sectors have detracted alpha in 6 years or more over the last decade in small caps.

Sector Alpha vs. Beta Analysis

Although hedge funds have detracted small cap alpha from all sectors, investors may want to know how it compares to the beta component of returns: have managers lost money in small caps because the market has not favored this market cap range, or have they lost money because they haven’t picked the right names within those sectors in a consistent way? What was the alpha/beta ratio?

The above questions are important, because when analyzing managers, we need to isolate skill from general market trends. Our results show that alpha, not beta, has been the predominant detractor across all small cap sectors during the last decade, except for financials. This means that, on average, hedge funds are bad at picking stocks within small caps, regardless of market and sector factors.

small cap alpha

Sector Contribution Analysis

However, this doesn’t answer an important question: of the beta component, how much came from sector performance vs. market performance? Were there sectors from which it was especially difficult to generate positive contribution above the market?

Our data shows there are three sectors that delivered negative sector contribution over the last decade in small caps: energy, financials, and utilities. This means that the associated benchmarks underperformed the overall market. If the hedge fund you’re evaluating created alpha in small caps in energy, financials, and utilities, it’s a more skillful fund in security selection than the rest of the industry.

Skills like this are rare, as proven by the Hedge Fund Universe alpha performance.

Energy: Market vs. Sector vs. Alpha Contribution (bps)

small cap alpha

Financials: Market vs. Sector vs. Alpha contribution (bps)

small cap alpha

Utilities: Market vs. Sector vs. Alpha contribution (bps)

small cap alpha

An Exception: EMS Capital

There are two main reasons why it is important to identify whether a hedge fund is losing money in small caps. On the one hand, if the manager’s objective is to generate alpha in small caps (hence, most of its exposure is allocated to that market cap range), it should be one of its primary sources of contribution. On the other hand, if small caps is not the focus of the manager’s strategy, it should not be a big drag on performance. Many managers actually lose the most money from those market caps, sectors, or geographies that are not core to their investment philosophy.

This is not the case of EMS Capital. Although historically, small caps have had a 15% average exposure in EMS’ portfolio, it has generated 715 bps of alpha ITD (June 2008- December 2015). Furthermore, if we look at the 3 sectors in which it has been especially difficult to deliver positive returns, EMS has done better than average:

Looking for skills among the universe of hedge funds can prove difficult. EMS is an example of a manager that has done better than average in these three small cap sectors.

Conclusion

Hedge funds on average haven’t generated alpha in small caps in the last decade. Indeed, they haven’t generated alpha in any sector within that market cap spectrum. For most of these sectors, the big detractor was the alpha component, while beta was, for the most part, positive. However, three sectors have delivered negative sector contribution within the beta component: energy, financials, and utilities. If a hedge fund generated small-cap alpha in any of these sectors over the last decade, it’s fair to say that it possesses security selection skills that not many in the industry do.

Our Methodology

Our contribution methodology decomposes the contribution of a specific position, or the overall portfolio, into 4 different factors:

  • Market contribution: It is the contribution attributable to the market. We use returns from the S&P 1500.
  • Sector contribution: It is the contribution attributable to the specific sector of each position. We map each security in the portfolio to its respective sector benchmark (e.g.: S&P 1500 Financials).
  • Security selection contribution: It is the contribution attributable to the active selection of each position within a sector. This is what we call “security selection alpha”, that is, the excess returns that any manager is aiming to achieve. We use the returns of each specific security.
  • Trading contribution: Managers can create or destroy alpha through their trading decisions. This contribution is categorized as the excess alpha from the intra-day or intra-month liquidation of positions.

Market and sector contribution together determine the relative contribution, or beta, of the portfolio, while security selection and trading contribution are considered the absolute contribution, or alpha.

Total portfolio contribution is simply the sum of the contribution of each specific security. In this article we have filtered the small cap positions of the HFU, that is, all the publicly filed positions that hedge funds have reported in the last 10 years. For sector contribution, we have applied additional sector filters, on top of small cap securities.

The Novus Guide to Win/Loss Ratio

A portfolio manager makes multiple decisions when managing capital, such as picking which securities to invest in, which geographies to allocate to, how to size each position, and how long to hold each position in the portfolio. All of these decisions impact returns and are a great window into a manager’s true investment acumen.

The win/loss ratio is a metric that helps quantify the efficacy of two critical decisions for managers: the sizing of trades and the timing of exits out of trades. In layman’s terms the win/loss ratio measures (on average) how much a manager makes when they’re right versus how much they lose when they’re wrong.

In this guide, we’ll focus on some basic observations and properties of the win/loss ratio. Download our latest guide for the most authoritative walkthrough of win/loss ratio and its applications.

What does the guide cover?

  • How win/loss ratio is calculated
  • Why it helps evaluate a portfolio
  • Ways to improve win/loss ratio
  • How win/loss ratio relates to batting average

Download our latest report to learn more.

the novus guide to win/loss ratio
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