Why Well-Designed Portfolios Don't Depend on Cap Size and Style Categories

    by James B. Cloonan

    Why Well Designed Portfolios Don't Depend On Cap Size And Style Categories Splash image

    It would be almost impossible to write a column about mutual funds today without mentioning the late trading abuses of last year.

    I firmly believe that, where such abuses were illegal, perpetrators should be prosecuted, and where they were unethical, the companies should suffer client wrath and loss of business. The amounts involved are not the issue.

    That having been said, from a purely economic viewpoint, the $5 million to $10 million that fund stockholders lost as a result of such behavior pales in comparison to the billions of dollars in fees charged to shareholders by mutual funds.

    Most of these fees and virtually all of the load costs to the investor are excessive. Fees and loads are charged, but the value of the service rendered is negative—the advice in 80% or more of the cases provides a return inferior to the market return (S&P 500).

    Fees vs. Performance: No Correlation

    Only a few mutual funds do better than chance—a topic I’ll be exploring in greater detail over the year. The mutual fund industry is one of the very few industries where success is determined by ad budgets and sales force size.

    Product quality—in this case, returns—has little to do with either fund size or management fees. Few of the large funds beat the S&P 500, and that is not a particularly tough target.

    Why individuals continue to invest in funds that consistently underperform, and in addition pay fees and loads for the privilege to do so, is beyond me. However, I will strongly defend their right to do it, as long as they are properly informed.

    Individual Investor’s Fund Portfolio

    On a happier note, the Individual Investor’s Fund Portfolio had an outstanding year, with an average return of 34.0% and a RiskGrade of 83. This compares to a return of 28.5% for the S&P 500 with a RiskGrade of 112.

    A RiskGrade is a measure of risk relative to all stocks worldwide during normal market conditions; a portfolio RiskGrade of 77 implies the portfolio has a risk 77% as high as the average risk of all equities in the world. RiskGrades for any portfolio can be found at the RiskGrades Web site.

    While smaller-capitalization stocks normally outperform large-cap stocks over longer periods, the small caps really had an exceptional year last year. For example, the Individual Investor’s Shadow Stock Portfolio—which is actually composed of the smallest of the small, or “nano-cap” stocks—was up 73.1%. [Complete updates for both AAII portfolios are available in the Model Portfolios area at AAII.com.]

    Table 1 shows the performance of the Individual Investor’s Mutual Fund Portfolio, as well as its component funds.

    In the first two columns of the table, the investment style and average market capitalization of the individual funds are indicated. However, there are a number of important points that need to be made about the terms used in the table.

    Small Caps But Large Category

    First of all, the market capitalization categories in Table 1 differ from most of the common categorizations. Why?

    There is considerable confusion about the long-term performance of smaller-cap stocks, largely because “small caps” are often lumped into one category, without differentiating among size more completely.

       What Cap Size Does Your Fund Wear?
    Much is written about the performance of stocks based on their market capitalizations—share price times the number of shares outstanding. Typically, however, the groupings are too large and, in particular, have too little differentiation among the smaller-cap ranges. In Table 1, we have further broken down the various market segments based on these average market capitalization categories:

    Category Market Cap
    Giant-Cap$8 billion and greater
    Large-Cap $3 billion to $7.9 billion
    Mid-Cap $1.5 billion to $2.9 billion
    Small-Cap $400 million to $1.49 billion
    Micro-Cap $200 million to $399 million
    Nano-Cap $0 to $199 million

    Most of the studies that compare the performance of small-cap stocks and large-cap stocks effectively leave out the performance of the micro-cap and nano-cap subgroups, as well as much of the small-cap universe. Some of these stocks are left out of the performance comparisons simply because they are underweighted—they represent such a small weighting in the performance index that they have little effect on the index. Others are simply not in the index. For example, the Russell 1000 and 2000 cover only 3,000 of some 8,000 listed stocks. Those left out often have been the best performers on average.

    While there are opportunities in all cap sizes, I believe there are many more opportunities in the smaller small-cap issues.

    Our own breakdown of market capitalizations (see box at right) divides all NYSE-listed stocks into six groupings; the result is more segments, particularly among the smaller caps. Even with our further breakdown of the small-cap market, the lowest capitalization groups—the micro-caps and the nano-caps—contain about half of all stocks, even when all unlisted stocks are eliminated.

    Do Stocks Have Style?

    Second, Table 1 uses my own divisions for what has been termed “style.”

    My current approach to assigning a “style” acknowledges the fact that there really is no such thing as a “growth” stock category. “Growth,” as generally used in describing stocks, is a euphemism for “lack of value.”

       A Matter of Style
    Although stock investment styles typically are divided into “growth” or “value” camps, stocks are generally assigned a style category based on their price-to-book-value ratio—the most common measure of value. The lowest ratio stocks are called “value” stocks, while the highest ratio stocks are called “growth” stocks (although a better term would simply be “low value” or “expensive”). Listed below are the five style categories used in Table 1, based on the price-to-book-value ratios of all stocks listed on the New York Stock Exchange. Since funds report holdings infrequently, average price-to-book-value ratios and average style categories are estimates.

    Category Price-to-Book-Value Ratio
    Very High Value 1.25 and below
    High Value 1.25 to 2.00
    Moderate Value (Blend) 2.00 to 2.50
    Low Value (Growth) 2.50 to 3.50
    Very Low Value (High Growth) 3.50 and above

    The basic approach is to rank stocks in order of price relative to book value, which is the most common measure of value. The lower ratios are called “value,” “high value,” and “highest value” stocks. The higher ratio stocks, instead of being called “no value” or “low value” stocks, are called “growth” stocks. The rationale is that if the investment community is ready to pay much more than a stock is currently worth in value terms, it must be because investors believe the stock is about to grow enough to justify the price. That’s a bit of a stretch, so we simply measure style by the degree of value.

    Please don’t confuse momentum stocks with growth stocks. Momentum stocks are stocks whose price is going up faster than the market as a whole. This is not what is meant when the term “growth” stock is used.

    The category ranges for value as used in Table 1 are given in the A Matter of Style box (see left).

    “Category” Diversification
    Although Table 1 indicates both the market capitalization and style for each of the component funds, this information is provided only for descriptive purposes—the Individual Investor’s Mutual Fund Portfolio does not use either the style or cap categories as selection criteria.


    By way of explanation, let me attack a popular notion—in my opinion, a misconception—about diversification.

    I believe that over the long run, there is no significant risk reduction benefit from diversifying across different investment style categories or market-cap size categories. I suspected this since the Individual Investor’s Shadow Stock Portfolio over the years, with about only 30 stocks, has frequently had lower risk than the S&P 500.

    Using the Russell indexes (for both size and style) for the past 23 years, I compared large-cap performance to small-cap performance and growth stocks to value stocks, and found that the risk level was not reduced by diversifying across either the Russell market cap or style groupings, or both. This is basically because the range of correlations within each group is just as wide as the range between the groups.

    As is the case with international stocks, there may be some risk reduction over the short term—in other words, one-year to three-year returns may be less volatile. However, equity owners should be in the market for longer time periods than that. Also, there is a significant reduction in return in exchange for this short-term risk reduction. In addition, any short-term advantage that comes from this relates to the performance of an entire sub-group.

    Well-chosen diversified portfolios will have correlations and risk levels below any general style or segment diversification, even in the short term.

    Refining the Criteria

    As I mentioned in my column introducing the Individual Investor’s Fund Portfolio in the September 2003 AAII Journal, some of our criteria need adjusting.

    We are now in the process of making several adjustments. For instance, the limits on a fund’s size should relate to the portfolio approach; similarly, expense criteria should vary with fund size.

    We are also developing a new measure—the consistency of a fund’s risk over time. This is important because our objective with the Individual Investor’s Mutual Fund Portfolio is not just to outperform the general market, but to do it with minimal exposure to loss.

    I will be reporting on these refinements in my next column on the Mutual Fund Portfolio. 

       Model Portfolios on AAII.com
    To access the Individual Investor’s Shadow Stock Portfolio and the Mutual Fund Portfolio, go to www.aaii.com/aaiiportfolios. The Model Portfolios area includes:

    • Current composition for each portfolio,
    • Monthly performance results for each portfolio,
    • Selection rules for each portfolio, and
    • Explanations of important concepts.
    Updates are posted after each month’s end.

    James B. Cloonan is founder and chairman of AAII.

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