You’re Almost Always Exposed to Some Variable You Didn’t Realize

Blogger King Felix Salmon has a good post highlighting the relative performance of mutual funds. Or more accurately, the consistent underperformance of most actively managed mutual funds.

What I find interesting is that the relative performance of the actively managed funds is fairly strongly correlated with the relative performance of small-cap stocks. It’s not so much that active managers suddenly got dumb one year after being smart the year before. It’s more about sector rotation.

It’s not so much that active managers “decide” to be in small-caps. The aggregate of all mutual funds has to, by definition, show a small-cap bias. The reason is that actively managed funds need to be diversified, and, ideally for them, not correlated with the indexes.

What’s most fascinating is that the relative performance of active managers is related to small-cap relative performance even in asset classes outside of small-caps. What this probably means is that within any sector, let’s say large-cap, the active managers crowd into the small-caps of that sector. Hence the small-cap bias still lives.

We can add another twist that small-caps’ outperformance is somewhat correlated with the dollar since larger companies have greater foreign exposure. The lesson for investors is that you’re often exposed to some market or variable even when you think you’re not.

Consider the case of Long-Term Capital Management. In 1998, the hedge fund found out that when Russia defaulted on its debt, that impacted many of their trades. They had no idea they were so heavily exposed to such an event.

Posted by on September 12th, 2012 at 10:29 am


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