October 2023 Commentary

We humans are shockingly prone to bad ideas, ideas that
grow into terrible decisions, and then metastasize into
actions that undermine, damage, or might even end our
lives. We’d all like to think that we’re a lot smarter than the
average, and some of us surely are, but an uncommonly
large number of us have a consistently bad track record of
decision-making and none of us is as good as we think we
are.

Worst of all, these weaknesses are largely opaque to us.
They leave no cognitive trace.

As humans, we want deductive (definitive) proof, which is
rarely available and therefore must settle for inductive
(tentative) theories. Induction is the way science works and
advances. That’s because science can never fully prove
anything. It analyzes the available evidence and, when the
force of the evidence is strong enough, makes tentative
conclusions in an effort to ascertain the best available
approximation of the truth.

Case in point. A friend that sits on a pension board was
explaining the process used by their investment consultant
to measure and propose a “proper” asset allocation.

Knowing our firm specialized in small cap equity, he
questioned the consultant on why the small cap asset class
wasn’t factored into the strategy. When challenged, the
consultant went on to say the small cap index did not
provide sufficiently uncorrelated return streams compared
to other asset classes to justify an allocation. Which, of
course, to us is heretical.

One of the fallacies built into asset allocation models, is
that the index is a good proxy for return characterization.
So, we looked to the eVestment database (a database &
tools for the institutional asset management community)
and found some very interesting facts. Going back to
December 1990 and measuring ten-year rolling periods,
the median large cap manager outperformed the S&P 500
Index 50% of the time, yet the median small cap manager
outperformed the Russell 2000 100% of the time and, in
most instances, by more than 250 basis points.

And, over those same periods, the Russell 2000 small cap
index only outperformed the S&P 500 33% of the time, yet
the median small cap manager outperformed the S&P 500
two-thirds of the time. So why are we using the Russell
2000 return stream to measure return characterization of
small cap allocations?

Though a shorter return history, small cap indices outside
North America over the same ten year rolling return
periods are similar. The MSCI EAFE Small Cap Index
exceeded the MSCI EAFE Index 100% of the time. And the
median manager also outperformed the small cap index
100% of the time – at times by as much as 400 basis points.
Very clearly, active management in small cap investment
outperforms indexation. Also, quite clearly a small cap
index should not be used in an asset allocation study.
This is not meant to disparage large cap managers or the
investment consultants that continue to tout them. It is
simply to suggest we should carefully evaluate evidence.
We should develop tentative conclusions. And we should
seek and accept disconfirming evidence. “In all affairs, it’s
a healthy thing now and then to hang a question mark on
the things you have long taken for granted,” as Bertrand
Russell explained. Too often we take expert opinion as fact
when our focus should be on making fewer mistakes.

Next month we will introduce the second part of our
trilogy, “Rethinking the Small Cap Asset Class”. If you
missed the first part, it can be found on our website here:
https://laurusglobalequity.com/wp-content/uploads/2024/12/Planning-for-the-Extended-Maturity-Cycle-of-Large-Cap-Equity-1.pdf