For anyone who has kept an eye on the financial media for any amount of time, you’ll be intimately familiar with “the lists.” These include things like “Top 50 Brokers”, “Top RIA,” “Best Funds” and so on. These publications are ubiquitous and a non-stop stream for the publishers. In total transparency, the ones that focus on individuals or firms tend to sell tickets to a gala or, more importantly, to sponsors. When a publication comes out with the “50 most handsome and smart financial professionals” list, that list coincidentally tends to consist of CEOs or lead advisors at firms with billions of dollars under management. While we might then simply think that the list is to be conflated with a “manages a lot of money” list, the purpose in those cases is actually to get those fifty people in a room with sponsors paying tens of thousands of dollars for a shot at marketing a fund or other product to them. After all, even winning 10% of the assets from an unscrupulous advisor who manages billions can, in turn, mean millions in fees or commissions to those firms.
Yet, there is another kind of list that I’d argue is more harmful than the “marketing to the successful advisor” list. That list is one that’s marketed to the retail investor: someone who isn’t a financial professional but who is keen enough on finance to try to “keep up with the news” in the investment world. The deep irony is that most financial professionals don’t read these lists or even the publications they’re in, but the uninformed public is none the wiser. However, these lists tend to be, frankly, garbage. Today, we’re doing a breakdown of one such list published in a legitimate financial publication and discussing the issues even a cursory review by a financial professional found.
Our subject du jour is from Barron’s, specifically: “Small-Cap Funds Are More Promising Than They Have Been in Years. Here Are the Ones to Buy,” published on October 11th. The list describes the macro-economic conditions relevant to small cap fund investing and why it may (publications will forever use the words “may” or “might” to shield them from regulatory scrutiny) be prudent to invest in one or more of the investment funds they’re listing. Here is the list.
- Avantis US Small Cap Value ETF (AVUV)
- Dimensional US Small Cap ETF (DFAS)
- Fidelity® Low-Priced Stock (FLPSX)
- Fidelity® Stock Selector Small Cap (FDSCX)
- FPA Queens Road Small Cap Value Investor (QRSVX)
- Fuller & Thaler Behavioral Small Cap Growth Investor (FTXNX)
- iShares Core S&P 500 ETF (IVV)
- iShares Russell 2000 ETF (IWM)
- iShares Russell 2000 Growth ETF (IWO)
- iShares Russell 2000 Value ETF (IWN)
- Needham Aggressive Growth Retail (NEAGX)
- Reinhart Genesis PMV Investor (RPMAX)
- Royce Small-Cap Special Equity Investment (RYSEX)
- SPDR® Portfolio S&P 600 Small Cap ETF (SPSM)
- Tributary Small Company Institutional (FOSCX)
- Driehaus International Small Cap Growth (DRIOX)
- Fidelity® International Small Cap (FISMX)
- Moerus Worldwide Value N (MOWNX)
How We’ll Evaluate the List
We will utilize a 3rd party evaluation system for looking at these investments, the Fiduciary Scoring System® by Fi360 and the Center for Fiduciary Studies. The criteria for each category are fairly generous, but in the aggregate, it can be challenging to accomplish for any investment fund or product. To receive a passing score in any dimension requires the following:
- Manager Tenure: Minimum of 2 Years to ensure continuity or improvement of prior manager’s performance.
- Product Assets: Minimum of $75 Million, which is small potatoes in the investment product world. Ensures that there is some form of market to provide liquidity.
- What’s Under the Hood?:
- Composition: 80% allocated to its stated composition. In this case, that would be at least 80% in either US Equities or International Equities, depending on whether the fund is stated as a domestic or international option in its prospectus.
- Style Drift: That the fund’s classification in the Morningstar Style Box matches its prospectus. So, in the case of a list of all small cap funds, every single fund should be a Small Blend, Small Value, or Small Growth fund in the style box. A fund that falls outside would, by definition, not be a small cap fund.
- Expense Ratio: In the top 75% of the peer group, or put differently, “not in the 1/4th of most expensive products in its peer group.” While officially it doesn’t score poorly if it’s below the 75th percentile in terms of cost, we will call out that we’re highly critical of any funds above the 25th There’s simply too much data that shows that fund manager’s performance is all too often not in excess of the market return when expenses are included.
- Alpha: For non-professionals, Alpha is a measure of manager performance. It compares the return of an investment fund to its underlying benchmark, the risk-free rate of return, and the volatility of the investment asset class to determine whether the manager is actually outperforming or not. This is measured for the past 3 years of returns.
- Sharpe Ratio: This is a measure of risk-adjusted return. If the Sharpe Ratio is low, that means the investment returns have been lower per measure of risk than if the Sharpe Ratio is high, indicating that the investment has produced more return per measure of risk. This is measured for the past 3 years of returns.
- 1, 3, and 5-Year Total Return: Brass Tacks, has the investment been in the top 50% of its peer group in the last 12, 36, and 60 months?
With our criteria selected, let’s take a look at what Barrons provided us, and see why much of the list is essentially rubbish.
Fortunately, all but one of the funds being recommended passed the basic requirements of governance. Each fund had a manager operating it for at least the past two years, and each fund had no less than $75 million in assets within the product, with the exception of the Moerus Worldwide Value N. Simply put, this fund is only a few years old and hasn’t really gained the traction or interest to grow its assets under management. Of course, as we’ll see as we move onto the next section, there are some fairly obvious reasons for that.
What’s Under the Hood?
One of the most common mistakes everyday investors make is trusting the label, or in other words, judging books by their covers. In this instance, the list from Barrons is chock full of issues in composition, style, and the cost of the funds. For example, the Fidelity Low-Priced Stock index is only 60% comprised of US companies, and the Needham Aggressive Growth Retail is sitting at 78%. While neither of these funds are described as being small cap funds, this still, of course, raises a simple question: If these aren’t labeled or billed as small cap funds, what are they doing on a list of small cap funds, and in particular, on an active “all cap” fund list that’s in an article titled “Small cap funds are promising… here are the ones to buy”, and an active small growth fund that isn’t really a small growth fund at all?
Then we get into style drift, and herein might be the biggest bunch of lemons I’ve ever seen. While many of the funds on the list are stated as small cap funds specifically, more than half of them are actually small cap funds. The Avantis US Small Cap Value ETF is comprised of less than 57% Small Cap Value. The Fidelity Low-Priced Stock index is as mentioned above, actually an all-cap index, and thus is less than 36% small cap. The Fidelity Stock Selector Small Cap is less than 77% small cap. The FPA Queens Road Small Cap Value Investor is less than 25% small cap value. Fuller & Thaler Behavioral Small Cap Growth investor is less than 54% small cap growth. The Needham Aggressive Growth Retail is less than 59% small cap. The Driehaus International Small Cap Growth is less than 5% small cap growth. The Fidelity International Small Cap is less than 59% small cap.
Of course, none of these is a better example than the iShares Core S&P 500 ETF, which is, no surprise, less than 1% small cap, given that the S&P 500 is an index that attempts to track the largest 500 companies in the US Economy, and thus, is dominated by large cap companies, then mid cap companies, and then the barely eligible small cap companies. Not to worry though, it’s included on the Barron’s list as an “index fund”, as if it was somehow going to squeak by pretending to be a small cap index fund.
Then there’s the expense of the funds. Now, we mentioned before that the Fiduciary Scoring system gives investment products a pass in this category if they’re not in the 1/4th of the most expensive products, but we feel that anything more expensive than the 1/4th least expensive should be called out, given how commoditized investment products have become and the issues with high expenses being strongly correlated with low performance. With this in mind, we have some whopping fees, ranging from 0.93% all the way up to 1.88%. For contrast, that S&P 500 ETF we just mentioned in the last paragraph only costs 0.03%, and even its cousins, the index-fund ETFs for the Russell 2000 only costs 0.19%-0.24%.
Then there’s performance, the ultimate put-up-or-shut-up of investing. After all, nothing else really matters at the end of the day: if the investment makes you money, and in fact, makes more money than its peer group, that’s all that really matters, right? So surely the funds on the list will be redeemed by incredible performance, that’s why a top finance publication is touting them, right? If you hear the buzzer in your head right now, accompany it with the word “WRONG.”
While many of the investments are managing to scrape by in the top 50% (e.g. “the coin came up heads a few times”) over the past one, three, and five years, plenty aren’t, including some such as the iShares Russell 2000 Growth, which sits in the 83rd worst percentile over the past five years at best and the 90th percentile of Alpha and Sharpe ratio at worst. Of course, it’s not alone, with the other Russell index ETFs scoring everywhere from a 53rd percentile Sharpe Ratio to an 87th percentile Alpha. This might hint at the “more promising” nature of a small cap investment hinted at by the title of the Barron’s article, but it actually says more about the Russell index than it does about the small cap market. Let’s see how.
The List’s Two Decent Candidates
Of all the investments in the list, only two stand out as decent and consistent performers over time. First, the Dimensional US Small Cap ETF (DFAS) has a “perfect score”, in that it did not fail or flag a single criterion of the Fiduciary Scoring System. A rare kudos to Dimensional, who we’ve been publicly critical of from time to time; credit where credit’s due. The other investment that actually sits in the small cap category and has performed well is the SPDR® Portfolio S&P 600 Small Cap ETF (SPSM), which trips only over the 3-year Sharpe Ratio in the 65th percentile. This simply reflects the high-risk nature of the small cap category when investing broadly more than anything. Of course, we should disclose here that at present, 3.81% of our investments under management are invested via SPSM, so take our explanation as to the Sharpe Ratio with a grain of salt.
Ultimately, the embarrassment of the entire list is that almost every fund they’re listing is a poor performer in one way or another, or several ways, for that matter. The only funds in the list worth their salt are a low cost factor tilt small cap fund, a low cost index fund tracking the S&P 600 instead of the Russell 2000 as an index for small cap assets, and a literal large cap balanced ETF in the form of the S&P 500 index ETF from iShares.
So the Lists Are Worthless?
It’s a fair question. What are you to take from this? That publications on investments, particularly any publication touting a specific fund or set of funds as good quality options, are only going to be as good as the people writing them. While I’ll decline to speak ill individually of the author of the particular list and article we’re reviewing here, it would seem prudent for anyone considering investing in any asset class to utilize an investment philosophy and their own research on the qualities of the underlying investments, rather than simply buying off a list from a trusted publication. After all, we have to keep in mind that the purpose of a financial publication or any other publication is to garner attention for its content, not necessarily to clearly educate or inform its audience. Of course, if you’re the type to work with a professional, leave the task of investment selection to them, and enjoy your day not scouring lists of bad investments to see whether there are any diamonds in the rough!
For Compliance: As disclosed above, MY Wealth Planners invests in SPSM on behalf of its clients, and those reading this should not take that as a form of endorsement or encouragement to buy or not buy that investment product. A critical analysis of an investment does not guarantee or influence its future returns, and historical performance is not a guarantee of performance. This blog, and all blogs by MY Wealth Planners are for educational purposes, not individualized investment advice.