Active management can add big value in small-cap equities

Principal Global Equities Active management can add big value in small-cap equities Brian Pattinson, CFA - Portfolio Manager Key points: Inefficiencies create opportunity Our approach to active investing is grounded in a powerful idea: compelling investment opportunities emerge from inherent inefficiencies. The small-cap universe is a corner of the market with inherent inefficiencies that can be exploited through fundamental analysis and stock selection. Active managers can be more selective Active managers are able to add value by being more selective in their investment choices. They can also have the advantage of including firms that are not included in passive investment strategies. Active share is positively correlated to excess alpha Our research indicates that active share positively correlates to excess alpha over time. This is especially important in the small-cap universe, which is much broader and more evenly distributed than the largecap universe. While the value and effectiveness of active management has been debated among investors, consultants, advisors, and academics for some time, the growth and expansion of passive investment options including index funds and exchange-traded funds (ETFs) over the past decade has added a new twist to the discussion. The question at the forefront of small-cap equity investor s minds is Has the growth of passive investments diminished the small-cap opportunity set? In this paper, we address this topic and some of the points that support why Principal Global Equities, along with many institutional investors and consultants, continue to embrace active management and advocate it over a passive approach to small-cap stocks. Opportunities arise from inherent inefficiencies Our approach to active investing is grounded in a powerful idea: compelling investment opportunities emerge from inherent inefficiencies. Therefore, less-efficient areas of the market will offer even more-abundant opportunities. The small-cap universe spans a broad, fragmented opportunity set that is unfamiliar to many investors and is prone to neglect. This results in a plethora of inefficiencies for active managers to exploit through fundamental analysis and stock selection. Greater opportunity for stock pickers to add value The irony of the active-versus-passive debate and something we find many investors often fail to recognize is that passive strategies can actually add to market inefficiencies, particularly within small cap. After all, passive strategies are not static portfolios. Rather, passive strategies continuously buy and sell stocks as quickly as possible, in order to stay true to their indices. Active management can add big value in small-cap equities 1

For example, a typical Russell 2000 index fund generates 15% to 20% turnover per year, simply because of index rebalancing. ETF index funds also experience significant turnover. For example, one popular Russell 2000 ETF with over $38 billion in assets had a daily trading volume that exceeded $3.8 billion (data as of December 30, 2016). 1 When investors buy these index funds, regardless of market-cap or style focus, they are blindly buying in bulk. In other words, they are not discriminating among stocks. Such forced buying and selling to rebalance these passive portfolios creates anomalies, noise, and inefficiencies at the margins. One such result is that the increase in passive trading volumes naturally leads to higher correlations between individual companies. This sets the stage for active management. An active manager with a disciplined investment process can sort through the disparate universe of small cap stocks, identify the best candidates and make precise portfolio decisions. Furthermore, active managers are not limited just to their indices for investment opportunities. There are hundreds of out-of-the index small-cap firms that are outside the realm of passive strategies, such as New issues Spin offs Restructurings Most notably fallen angel companies that simply slide into the small-cap zone between index rebalances are examples of such opportunities. The small-cap advantage The small-cap advantage is evident when reviewing the historical outperformance of active managers versus the index. This holds true for both U.S. and non-u.s. when comparing small-cap to large-cap universes. To take this a step further, it is also evident when comparing the universe median versus the index. Exhibit 1: There s a clear historical advantage in small-cap equities. % Outperforming index Universe median vs Index Benchmark evestment Universe 3 yrs 5 yrs 10 yrs 3 yrs 5 yrs 10 yrs U.S. S&P 500 US Large Cap Equity 25% 36% 62% -1.11% -0.62% 0.37% Russell 2000 US Cap Equity 55% 62% 77% 0.45% 0.80% 1.27% US small vs large advantage 31% 26% 16% 1.56% 1.42% 0.90% Non- U.S. World ex-us Large Cap ND EAFE Large Cap Equity 80% 88% 84% 1.09% 1.76% 1.22% World ex-us Cap ND EAFE Cap Equity 76% 92% 87% 1.48% 3.17% 1.73% International small vs large advantage -4% 4% 3% 0.39% 1.41% 0.51% Source: evestment Alliance Data shown as of 30 December 2016. For additional information, please refer to the disclosure section. Active management can add big value in small-cap equities 2

We are often asked How active and different is your manager? We suggest this question How top-heavy is your benchmark? To get a sense for how top-heavy the index is and how much overlap is likely to exist for portfolios managed against each, you can look at the concentration of the top-ten holdings of various indices. As Exhibit 2 illustrates, the small-cap universe is not as top-heavy as large-cap indices. Overall, there is less index concentration making it easier to have an active share that is different than the benchmark. Exhibit 2: Less concentration of an index s top-ten holdings means a high active share is easier to achieve. 25% Index weight 20% 15% 10% 5% The small-cap universe is much broader, and more evenly distributed, than the large- cap universe. Less overlap with benchmarks (i.e., higher active share) provides active managers increased ability to add value. 0% S&P 500 Russell 2000 Japan Japan Europe Europe EM EM ACWI ACWI Source: S&P 500, Russell, Data shown as of 30 December 2016. For additional information on, please refer to the disclosure section. Active management can add big value in small-cap equities 3

-cap benchmark mechanics also lend an inherent advantage for active managers Active small-cap managers also gain an inherently valuable advantage from the mechanics of small-cap benchmarks. In order to outperform an index, a portfolio needs to be different than the index. To this point, we believe the active-share ratio is an important measure. Active share measures aggregate differences in portfolioholding weights versus the benchmark-constituent weights. More specifically, our research indicates that active share effectively measures the excess-return potential of a portfolio and positively correlates with excess alpha over time. Characteristics of the benchmark Tend to be diversified (not top-heavy) Benchmark: Large-cap -cap Inherently easier to construct high active-share portfolios Benchmark: Large-cap -cap A hypothetical example will better illustrate the top-heavy nature of large-cap benchmarks. Assume a manager wants to take a 1.5% overweight position in the largest stocks in the S&P 500 and the Russell 2000. As the chart below illustrates, taking the same overweight position leaves the manager with a 4.7% weight in the large-cap index stock, but a 1.9% weight in the small-cap one. Greater potential for active manager to add value Benchmark: Large-cap -cap Example scenario Index S&P 500 Russell 2000 Largest stock Apple (AAPL) Advanced Micro Devices Inc. (AMD) Index weight 3.21% 0.45% An investment manager takes the same overweight position in the company. 1.50% 1.50% Investment in stock 4.71% 1.95% Source: S&P 500, Russell 2000. Data shown is as of 30 December 2016. Chart shown is for illustrative purposes only. It takes more than twice the portfolio allocation to achieve the same overweight position in large-cap versus small-cap. This is a 2.76% difference, that the manager can use to invest outside the benchmark holdings to maximize alpha potential. Active management can add big value in small-cap equities 4

Exhibit 3: -cap portfolios achieve a consistently higher active share, regardless of the number of stocks in a portfolio. 100% Active share ratio 75% 50% 25% Stock count often used as a crude measure of a portfolio s activeness has a much more dramatic effect on the active share of portfolios managed against a large-cap index than a small-cap index. 0% 25 50 100 250 500 Portfolio stock count World Ex-US Cap Russell 2000 World Ex-US S&P 500 Source: S&P 500, Russell 2000, Data shown as of 30 December 2016. For additional information on, please refer to the disclosure section. A strong case for active management The case for active management of equities and long-term investment portfolios remains strong, despite the recent growth in passive investment strategies. The small-cap universe is particularly compelling given its size and the limited availability of research. This provides active managers the opportunity to generate alpha beyond what passive strategies can provide. Perhaps, it is no surprise that large-cap and mid-cap managers often buy small-cap exposure from outside their benchmark in an effort to reduce overlap, increase activeness, and bolster alpha potential. About Principal Global Equities Principal Global Equities is a specialized investment management group within Principal Global Investors. We are fundamental investors, focused on bottom-up stock selection, providing client-focused investment solutions spanning equity markets worldwide. We are distinguished by a globally integrated culture that embraces collaboration, the unified adherence to a distinctive bottom-up stock selection investment philosophy and process, and the ways we leverage technology to consistently and effectively manage portfolios and client relationships. 1 Morningstar Direct. Data shown as of 30 December 2016. Active management can add big value in small-cap equities 5

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