Billions invested in indexes that were never designed to be investments
The benefits of passive investing have been touted for years by legendary investors like John Bogle and Warren Buffet. Investors have listened.
Every year, hundreds of billions of dollars shift from active strategies to passive index investing – and with good reason. It is well documented that close to 85% of active managers consistently underperform their benchmark indexes.
Add on the lower costs of index investments, and what is not to like?
When it comes to small cap stocks, quite a bit.
The good, the bad and the ugly of market beta
The benchmark index for small cap stocks is the Russell 2000, an index designed to be representative of the market beta of all small cap stocks. The problem is that it includes the good and the not so good.
Even though the Russell 2000 was not originally designed to be investable, it currently supports more than $37 billion in ETF assets. Which is unfortunate for long term investors, because in any given year close to 30% of the companies in the Russell 2000 have negative earnings.
While some small companies can eventually turn a profit, investing in companies that lose money is generally not a winning long-term strategy for investors…especially when the companies are small. Plus, many small cap stocks don’t make for good long-term investments due to:
- Volatility: Small cap companies are inherently more volatile than larger companies. Revenue streams are more concentrated, and small events can mean big changes. Access to capital markets is more challenging. This can all lead to fear-inducing price swings.
- Under-reported issues: The sheer number of small cap companies results in them being underfollowed by Wall Street. This means fewer analyst reports and less coverage. Investors are forced to rely on their own research, which often means that professional investors who have the time and resources to do their own research and ferret out problems have a distinct advantage. When that informational advantage leads them to short a stock, or bet it will go down in value, it is often in response to a real issue with the company.
When less is more
If you build an index that starts with the universe of small cap stocks and focus in on the highest performers, you get more than market beta — you get enhanced factor beta.
The recently launched BRI Quality Small Cap Index (BRIQSC), with Wilshire retained as index consultant and calculation agent, does just that by eliminating companies that:
- Lose money
- Are the most volatile, and/or
- Have a high short interest
As can be seen in the chart, the difference between market beta and enhanced beta is substantial, especially during market declines. In 2008, the drawdown was about half of the Russell 2000s. In a challenging 2011, the BRIQSC ended the year positive.
So how passive is your index really? Too passive? Passive investing can make a lot of sense. But investing passively with a little common sense is smarter — and enhances your beta, too.