Investing in Micro Cap Stocks

Microcap Millionaires

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Microcap Millionaires Overview


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The Portfolio Contribution of Micro Caps

The simplest way to demonstrate the contribution of micro caps to the asset allocation process is to look at some simple what-if simulations involving micro cap stocks along with other large asset classes. In this instance, the portfolio benefit of micro caps is examined, but the analysis can easily extend to showing the benefit of other asset classes such as international stocks and real estate investment trusts. The examples are designed to be simple and to prove the case that micro caps as an asset class add value in the multiasset portfolio. In the case of real-life asset allocation situations, consultants and fiduciaries put constraints on the minimum and maximum asset allocation for any given asset class. The specific investment policy and existing nature of the portfolio dictate these constraints. The tax status of a portfolio may have an effect on the amount of income-producing assets that might be targeted for a portfolio. In a taxable portfolio, the allocation may be skewed...

Valuation Growth versus Value Large Cap versus Small

Often we read about mutual funds and investment managers specializing in value stocks or growth stocks or large cap stocks or small cap stocks. How should the classification of a stock into one of these categories affect its value Large cap stocks are stocks that have market capitalization of equity in excess of 5 billion. Mid cap stocks have market equity of 1 to 5 billion and small cap stocks have market capitalizations that generally are less than 1 billion. Depending upon the cycle of the moon and recent successes or failures in fund management, different investing approaches either come into or go out of favor. Investors concentrating in large caps performed well during the 1997-1999 stock market climb with gains in the S& P 500 of 31 percent, 26.7 percent, and 19.5 percent, before reversing course to 10.1 percent in 2000, 13 percent in 2001, and 23.4 percent in 2002. According to Siegel, small cap stock returns exploded during the period between 1975 and 1983, when the...

Portfolio of Small Cap Lightly Followed Stocks

Based upon the information provided in the last section, you could go about constructing a portfolio of small-cap, lightly followed stocks using the following criteria Market Capitalization Cut-off As you can see from figure 9.7, even a maximum market cap of 10 million would yield more than a thousand firms. Since many of these firms with small market capitalizations are likely to be either in trouble or difficult to even buy stock in, a minimum market capitalization of 10 million will be required. The maximum market capitalization is set at 50 million to allow for other constraints to be built into this portfolio.

Microcap Risk And Return

The fact that dividends are not a factor simplifies our discussion about the returns from microcap stocks. compass quadrants. Microcap equities are unquestionably found in the Northeast quadrant (see Figure 10.1). If Figure 10.1 were an approximation of a map of the continental United States, the argument would be whether these stocks are clustered around Albany, New York, or Bangor, Maine. This depends on what issues are included in the category. If one includes the most recent Center for Research in Securities Prices (CRSP) data for their deciles 9 and 10, then Bangor is the spot. The CRSP deciles are created by taking all of the New York Stock Exchange (NYSE) stocks (other than ADRs, REITs, and closed-end funds) and dividing them into 10 groups ranked by market cap. Decile 1 is composed of the largest companies. The AMEX and Nasdaq stocks are then added to the appropriate deciles. If one were to segment deciles 9 and 10 into the style classes of growth or value, then the microcap...

Small cap and large cap

In the early 1980s Rolf Banz published research which highlighted the surprising superior performance of smaller companies compared with larger companies. This result has been replicated on numerous occasions since for the United States, the UK and other countries, with a general pattern that the smallest, or micro-companies, have outperformed small companies, which in turn have outperformed large companies. The historic outperformance of smaller companies is the small cap effect or the small cap anomaly, because, although small companies tend to be more volatile than large companies, the degree of outperformance could not be explained by the original simplified capm model. ical performance of small and large capitalisation companies. Figures 7.1 overleaf and 7.2 on page 99 make use of the comprehensive database maintained by the Center for Research in Security Prices at the University of Chicago. They contrast the performance from 1925 to early 2006 of the largest US companies...

Microcap Segmentation And Benchmarks

Microcaps command very little attention from that largest of institutional pools, public, and private defined-benefit pension plans. Consequently, consultants, investment managers, or brokers have not been motivated to underwrite or undertake any sustained compilation of segmented microcap benchmarks. There have been attempts by some Web sites to construct microcap growth stock indexes. They have not been successful. Delistings and bankruptcies compounded the difficulties in developing a representative group of stocks in any meaningful and representative quantity. Experienced microcap investors will tell you that most microcap stocks are considered growth stocks. They have discovered that the small number of value plays are really a variation on vulture investing. The other micro-cap issues either demonstrate sustained growth or they fail. So a benchmark comprised of all microcaps is a close proxy for microcap growth stocks (allowing for some survivorship bias). Does such a benchmark...

US Small Caps

The small-cap asset class is where investors go to get an extra pop in the stock market, but watch out They are more volatile. As the asset class that was left farthest in the dust during the late 1990s, small-cap stocks were perhaps the ones with the best chance of a rebound and showed strength in 2002. This is suggested by their long-term strength and by the tendency of returns to revert to the mean. Not only are small-cap stocks volatile as a group, their internal components are volatile as well. Consider that in the first quarter of 2002 small-cap value stocks were the best performing major asset class and small-cap growth stocks were worst.3 One of the strange anomalies of small-cap Figure 11.3 Small Cap Growth and Value in Late 1990s Figure 11.3 Small Cap Growth and Value in Late 1990s One explanation for this is that when successful small technology companies rocket out of the small-cap arena, much of the benefit is captured by the mid-cap asset class as they continue to...

Small Cap Investing

One of the most widely used passive growth strategies is the strategy of investing in small companies, with small defined in terms of market capitalization. While you could construct a value oriented, small cap portfolio, most small cap portfolios tend to be tilted towards growth companies, and we believe that this category fits better in this chapter. We will begin by reviewing the empirical evidence on small cap investing, and then look at the requirements for success at this strategy. The Small Cap Effect If we look at value weighted portfolios, the smallest stocks earned an annual return of about 20 over the period as contrasted with the largest stocks which earned an annual return of 11.74 . If we use an equally weighted portfolio, the small firm premium is much larger, an indication that the premium is being earned by the smallest stocks. In other words, to capture the small cap premium, you would have to invest in the very smallest companies in the market. Nevertheless, these...

The Public Private Bridge

There is a large body of academic literature on the principal agent problem in private venture capital transactions. This literature focuses on the conflict of interest between an agent who is an entrepreneur needing financing and a principal who is the investor providing the funds for the venture. The theory has identified a number of ways in which the investor or principal can mitigate these conflicts. First, the investor can engage in information collection before deciding whether to invest, in order to screen out unprofitable projects or bad entrepreneurs. Second, the investor can engage in information collection and monitoring once the project is under way. Third, the allocation of cash flow between the entrepreneur and the investor can be designed to provide incentives for the entrepreneur to behave profitably. In these three approaches, we can find a series of information advantage opportunities that may also be found in the micro cap arena. In the first instance, when...

Management Management Management

As in any business, the quality of the management is a key factor in determining the success of the enterprise. In most cases, the skill and vision of the key management team will determine the long-term success of an enterprise. And the smaller a company, the larger the impact of the top management team. In a micro cap company, the top tier of key management people has a disproportionately large influence on the success or failure of the company. Unlike large companies, in most micro cap organizations the key management people also have direct responsibility for actual business execution. This is an important difference between the big and the small enterprise. Success in the micro cap world requires a certain management skill set that merges big corporate vision with a high level of entrepreneurship. So in micro cap companies, for practical purposes, the single largest contributing factor in corporate performance is attributable to the top management team. This suggests that finding...

Material Current Events Form 8K

This form is not filed on a regular basis, as Form 10-K and Form 10-Q are. However, this form is filed whenever a key event occurs at the corporate level. It often discloses material items not found in any other corporate filing. These data are especially important to small and micro cap companies because they may not be disclosed in any other venue outside of Form 8-K. There are 14 specific items that must be disclosed in Form 8-K The key item to remember is that these SEC reports constitute an excellent source of information for an initial review of a micro cap company. After reviewing these forms, it is easy to decide whether you want to move on to secondary sources of investment information as described or if in general you have determined that the company would be of further interest. It is important to become familiar with these basic SEC reports and review them as a part of your due diligence process when looking at any new potential micro cap investment.

Appear Cheap Relative To Large Stocks

Micro cap companies, particularly fast-growing micro cap companies, often have financial requirements that are different from those of larger companies in mature industries with established product lines. These differences can lead to some striking valuation differences between the financial ratios of micro cap stocks and those of their larger-company brethren. It is often most notable in the dividend policies of small versus large companies. Micro cap companies in general pay little or no dividends. It is estimated that only 26 percent of micro cap companies currently pay a dividend, compared with 88 percent of S& P 500 companies. In fact, dividends are even more prevalent among small cap companies as defined by the Russell 2000, where 49 percent of companies currently pay a dividend. In addition, the average yield among micro cap stocks is much smaller than the average yield among S& P stocks. For example, it is estimated that the average yield among micro cap stocks is...

Low Priceto Earnings Ratio

It sounds very cliched, but low P E stocks in the micro cap world will ultimately be recognized. Many academic and investment studies point to low-P E stocks as a powerful indicator of future stock performance. It is important to note that the low P E in the micro cap world is the trailing or historic P E. Because there is a general lack of analyst coverage of micro cap stocks, the ability to get a consensus forward earnings estimate is nearly impossible. Without direct guidance from the company, it is possible to estimate future earnings only by building a company financial model to estimate those earnings. This is not something the individual investor will typically undertake. However, finding companies that are trading at a low multiple of past earnings is a simple screen that can be used on most Internet stock screening sites. Again, because there are very few analysts that cover the micro cap world, these companies often post a strong change in earnings trend and trade at a low P...

Priceto Book Ratio

This is such a simple ratio that it is often completely ignored by the professional investment community. However, research indicates that a low price-to-book ratio is an excellent basic tool to use when screening for micro cap stocks. Generally, a price-to-book ratio of less than 1.5 to 1 is a useful level at which to begin screening. It is often a surprise to find that there might be a large group of companies that are trading at below book value. These companies are worth some study. Many have serious problems or potential problems. But in many cases routine screening can produce a list of financially healthy and growing companies with no obvious business problems that are trading at a market price below book value. It is important to note that book value must be carefully studied when analyzing these opportunities. Tangible book value, sometimes referred to as hard book, is the book value after it is adjusted for intangible assets such as intellectual property or goodwill that may...

Skin In the Game

A review of the proxy statement filed January 28, 2000, showed that company insiders owned just over 20 percent of the outstanding shares of the company. Of more interest was the listing of beneficial owners of over 5 percent not affiliated with the company. This list included Lord Abbott & Company, the well-known value managers from New York City DePrince, Race and Zolo, a private investment company from Orlando, Florida as well as Dimensional Fund Advisors and General Re Corporation, an affiliate of Berkshire Hathaway, Warren Buffett's company. Thus, we can see that Garan had a number of interesting indicators that could potentially signal an opportunity from an investment point of view. To begin with, the valuation level looked quite compelling relative to other micro cap companies as well to other companies in the garment business, both public and private. As discussed in

Market Price Formation

Limit orders and stop orders form the market microstructure the volume-price distributions on the bid and ask sides of the market. The concept market liquidity is used to describe price sensitivity to market orders. For instance, low liquidity means that the number of securities available at the best price is smaller than a typical market order. In this case, a new market order is executed within a range of available prices rather than at a single best price. As a result, the best price changes its value. Securities with very low liquidity may have no transactions and few (if any) quotes for some time (in particular, the small-cap stocks off regular trading hours). Market microstructure information usually is not publicly available. However, the market microstructure may be partly revealed in the price reaction to big block trades.

Mutual Funds An Investment

I know that, but please bear with me. I don't want to make the mistake that I see so many investment writers (and financial advisors) make starting with the more advanced stuff on the assumption that you know the basics. So often I hear from people reading about mutual funds and complaining that a writer starts throwing around terms such as small cap value stock fund and asset allocation without explaining them, and before you know it, you're lost in the weeds and frustrated. You have every right to be. Mutual fund terms, such as municipal bond fund or small cap stock fund, are thrown around too casually. Fact is, thanks to our spending-oriented culture, the average American knows cars a lot better than mutual funds. In this chapter and the next, I explain the investment and mutual fund terms and concepts that many writers assume you already know (or perhaps don't understand well enough themselves to explain to you).

Understanding how market capitalization affects stock value

Small cap, mid cap, and large cap aren't references to headgear they're references to how large the company is as measured by its market value. Here are the five basic stock categories of market capitalization Micro cap (under 250 million) These stocks are the smallest and hence the riskiest available. Small cap ( 250 million to 1 billion) These stocks fare better than the microcaps and still have plenty of growth potential. The key word here is potential. 1 Mid cap ( 1 billion to 5 billion) For many investors, this category offers a good compromise between small caps and large caps. These stocks have some of the safety of large caps while retaining some of the growth potential of small caps. From a safety point of view, the company's size and market value do matter. All things being equal, large cap stocks are considered safer than small cap stocks. However, small cap stocks have greater potential for growth. Compare these stocks to trees Which tree is sturdier a giant California...

Word of Caution about the

Besides the Dow Jones and the Nasdaq Composite, investors follow many other important benchmarks. The NYSE Composite Index, which measures the performance of every stock traded on the New York Stock Exchange, represents an excellent broad market measure. The S& P 500 Index, composed of the 500 largest publicly traded companies in the U.S., also presents a widely followed broad market measure, but, like the Dow is limited to large companies. The Russell 2000 compiles 2000 small-cap stocks, and measures stock performance in that segment of companies. Note that Wall Street money managers tend to measure their performance against one of these market indices. Big-cap and small-cap At a basic level, market capitalization or market cap represents the company's value according to the market, and is calculated by multiplying the total number of shares by share price. (This is the equity value of the company.) Companies and their stocks tend to be categorized into three broad categories...

The Theme of Your Portfolio

If you are aware of your investment theme, you should be able to glance at your portfolio and see that theme reflected in your trades and the structure of your portfolio. To truly understand this principle, let us look at the most basic example, which is prevalent in mutual funds. Assume that you are a fund manager of a small-cap value fund. The investment theme of the fund is to find stocks with small market capitalizations (i.e., 500 million or less) that are relatively cheap based on some criteria such as price-to-book and price-to-sales ratios. You will only investigate and invest in small companies that meet your thematic criteria and select the companies that best represent your trading theme. Of course you will also be concerned with future growth prospects, earnings, and capital appreciation. If we were to look at the stocks listed in your fund, we should be able to notice that all the stocks you are invested in appear to be small companies, that is, we will not find GE, MSFT,...

Index fund investing the relatively new passive investment strategy

This does not deny the possibility that a limited number of active managers might consistently outperform their comparison benchmarks. For example, having divided a sample of money managers into six asset classes, Gupta et al.15 discovered that the top quartile added value in all asset classes over the 1992-1997 period. However, after stress-testing their result, they realized that this performance lasted for only the top-quartile managers of three classes US Fixed-income, small-cap, and emerging markets equity. For large-cap equity, they did not find any evidence that top US managers tend to outperform their benchmarks over time for this asset class, extended period rankings tend to be random.

Focusing on the short term

If you look at a period of a single year, stocks have a mixed-performance record compared with other investments, such as bonds or bank investments. In 1999, big-company stocks grew an average of 25 percent, and small-company stocks averaged a blistering 50 to 70 percent, but bank accounts and various bonds ranged only from 1.5 to 7 percent. In the year 2000, the

Bills Bonds and Stocks 19262001

Large Stocks in Table 5.3 refer to Standard & Poor's market-value-weighted portfolio of 500 U.S. common stocks selected from the largest market capitalization stocks. Small Company Stocks are represented by the Russell 2000 Index as of 1996. Stocks in this portfolio rank below the 1,000 U.S. largest-capitalization stocks. Prior to 1996, Small Stocks were represented by the smallest 20 of the stocks trading on the NYSE.

An Integrated Approach

Hiring a PR group to run the IR function can have problems at its very core. IR demands an integrated approach where IR and PR strategies are discussed and overlapped to maximize the event for all company constituents. Easier said than done, however, when budgets preclude two senior professionals from each discipline. There are alternatives, however. A solid program, particularly at a small-cap company, uses inside and outside help to achieve stated goals.

Harald Mcpike Hedge Fund Nassau

Paul Samuelson

Over time the hard efficient market line has softened into a Risk Premium (RP) camp. They feel that markets are basically efficient but one can realize extra return by bearing additional risk. They strongly argue that, if returns are above average, the risk must be there somewhere you simply cannot get higher returns without bearing additional risk they argue. For example, beating the market index S& P500 is possible but not when risk adjusted by the CAPM. They measure risk by Beta, which must be greater than one to receive higher than market returns. That is, the portfolio risk is higher than the market risk. But they allow other risk factors such as small cap and low book to price. But they do not believe in full blown 20-30 factor models such as described in Chapter 25. Fama and his disciples moved here in the 1990s. This camp now dominates the top US academic journals and the jobs in academic finance departments at the best schools in the US and Europe.

Figure 42 Average Turnover Rates for Morningstar Categories versus Representative Index Funds 2002 through 2006

Turnover is average of five calendar years ending 2006. Representative index funds include Schwab S& P 500 Index Investor Class for Large Blend, Schwab Small Cap Index for Small Blend, and Vanguard Developed Markets Index for International Large Blend. Source Research Affiliates, LLC.

The Covariance Matrix

The factor covariance matrix plays a key role in the determination of the risk. It is in fact a square matrix. In a model with k factors, the dimensions of the covariance matrix is k x k. The diagonal elements form the variance of the individual factors, and the nondiagonal elements are the covariances and may have nonzero values. A nonzero covariance implies that the returns of two explanatory factors share some correlation. For example, consider the situation where market capitalization and the leverage of the firm are used as explanatory variables. It is not uncommon within an industry to find that the small cap names have a high amount of leverage. If we assume that the small cap names outperformed the overall market, then we can expect to see a nonzero correlation between the returns attributed to the leverage and capitalization factors. Hence, it is possible to have nonzero entries in the offdiagonal elements of the covariance matrix.

Varieties Of Mutual Funds

Small-cap funds are made up of smaller, lesser-known companies that the mutual fund thinks show great promise and will grow substantially over a few years. While many people think that small-cap stocks have performed better than other sectors have, small-cap funds, like the underlying small-cap stock, have fewer capital resources, and are known to be more volatile than their larger counterparts.

Risk Characteristics of Investments

While definitions vary, small-capitalization typically means any company less than 300 million, mid-capitalization constitutes 300 million to 1.5 billion, and large-capitalization is the label for firms in excess of 1.5 billion. As would be expected, large-capitalization stocks primarily constitute well-established companies with long standing track records. While this is generally true, the tremendous growth of new technology companies over the past decade has propelled many fledgling companies into the ranks of large-capitalization. For instance, Microsoft has a market-capitalization in the hundreds of billions of dollars and is one of the largest companies in the world. In the same way, small and medium capitalization stocks not only include new or under-recognized companies, but also sometimes include established firms that have struggled recently and have seen their market caps fall. As you can imagine, there are many combinations of size and style variations and equally as many...

Diversification Our Recommendation

Let's assume that no individual stock tickles our fancy. We would have our entire stock allocation in no-load mutual funds. What types of funds Since mutual funds themselves provide significant diversification, we would focus on just a few areas domestic large cap and small cap value, domestic large cap growth, an international fund, and a domestic fund with exposure to the real estate market. A large cap We also combine the proportions of individual stocks and mutual funds to achieve our desired stock asset class allocation. Let's assume that we want to maintain the following stock allocation percentages domestic large cap value 35 percent, domestic small cap value 25 percent, domestic large cap growth 20 percent, REIT 10 percent, international equity 10 percent. For instance, if we own a 5-percent position in an individual REIT stock, we would invest 5 percent in the no-load REIT fund. If we have 5-percent positions in the stocks of Cisco and Intel, we would invest only 10 percent...

Investment Strategy and Total Trading Costs

Keim and Madhavan illustrate the interrelationship between total trading costs -implicit (including price impact and opportunity costs) as well as explicit (commissions and spreads) - and investment strategies.17 Not surprisingly, they find that strategies that require large block trades have much higher total trading costs than strategies with smaller trades. They also find that the total trading costs are much greater for investors who buy small stocks as opposed to large ones. Table 5.3 provides a summary of their estimates of total trading costs for small cap and large cap companies listed on the NYSE and NASDAQ from 1991 to 1993.

Step V Determine Valuation

The means and medians for the Mid-Cap and Small-Cap comparables universe helped establish an initial valuation range for ValueCo, with the highs and lows providing further perspective. We also looked to the Large-Cap comparables for peripheral guidance. To fine-tune the range, however, we focused on those comparables deemed closest to ValueCo in terms of business and financial profile namely, Lajoux Global, Momper Corp., and McMenamin & Co., as well as Adler Industries and Lanzarone International to a lesser extent.

The Capital Asset Pricing Model

Sharpe's first step was to sidestep the need to make calculations for each potential security to be considered for a portfolio. Instead, for each security there is a factor that is very influential in the security's performance. For stocks and bonds, the primary factor determining price changes is the appropriate market index. The primary factor for large company stocks, for example, usually is the Standard & Poor's 500 Index, though there are alternatives, such as the Russell 1000 Index. A small company stock index, such as the Russell 2000 or S& P 600, is the primary factor determining the performance of the stocks of smaller companies. The Lehman Brothers Aggregate Bond Index is the primary influence on bond prices. Portfolio construction under CAPM focuses on asset classes U.S. large company stocks, U.S. small company stocks, developed market international stocks, emerging market international stocks, and the like. Determining an efficient portfolio requires calculations for...

Myth 2 indexing doesnt work in a Stock pickers market

At least this myth is based on plausible logic. The notion here is that information about large caps is more abundant and widely disseminated than information about small caps. Large-cap stocks generally have dozens of top-notch analysts modeling performance and posting recommendations for all to see, and far more fund managers sift through this information carefully. Small-cap stocks, on the other hand, may be lucky to have one or two analysts, and reports are likely to be far less thorough and widely read. Nearly every theory of market activity predicts there is more value to a fund manager reading reports and doing original research concerning companies that are less visible. Unfortunately, the numbers don't show any better performance for active small-cap managers relative to their indexes than large-cap managers, especially after taxes.1 One likely reason for this is that hidden transaction costs such as bid-ask spread and impact are greater in the small-cap arena, so any passive...

Outperforming the Market

Table 6-1 shows the compound annual return from 1926 on stocks listed on the New York Stock Exchange, sorted into deciles according to their market capitalization. The top two deciles, containing firms with over 3 billion in market value, are often called large cap and comprise most of the S & P 500 Stock Index. Deciles three through five, with market caps ranging between 750 million and 3 billion, are called mid caps deciles six through eight ( 200 million to 750 million) are called low caps and the smallest 20 percent (below 200 million) are micro caps.4 To take transaction costs into account, some of the small stock indexes currently use the actual return on the Dimensional Fund Advisors 9 10 Fund, an index fund that invests in micro caps. Costs of running this fund, which skillfully positions blocks of stock for purchase or sale, averages only 0.65 percent per year. Few money managers, not to say individual investors, can approach these low costs of transacting in the micro cap...

Testing market efficiency

Unlike the variance-based measures in the last section, Jensen's alpha does not penalize sector-specific funds that are not diversified because it looks at the beta of a portfolio and not its standard deviation. The measure's fidelity to the capital asset pricing model, however, exposes it to all of the model's limitations. Since the model has historically under estimated the expected returns of small cap stocks, with low PE and low price to book ratios, you will tend to find that strategies that focus on stocks with these characteristics earn positive excess returns. To the extent that the arbitrage pricing and multi-factor models are less likely to yield biased returns for small cap and low PE stocks, you could argue that the excess returns from these models should give you better measures of performance. The biggest problem that you run into in using these models to evaluate the excess returns earned by a portfolio manager or a strategy is that the portfolios themselves may be...

Unease On Main Street

Go's Driehaus Capital Management Inc., has doubled his stake in tech stocks in the past six months, to 20 of the Driehaus Small Cap Growth portfolio. He favors Net advertising, sales, and infrastructure companies, such as 24 7 Real Media, Getty Images, Digital River, and Google.

Figure 92 Expense Ratio and Transaction Cost Differences Silent vs Benchmark Index Funds

SMALL-CAP SILENT Like benchmark indices, silent indices for self-indexing funds incur some market-impact transaction costs when a portfolio is changed, even if market impact is not exacerbated by publication of the index change before the fund has an opportunity to trade. Our estimates, based on the assumed annual expenses in FiGuRE 9.2, show a minimum net disadvantage for large-cap benchmark index ETFs of 20 basis points (0.20 percent) and a maximum net disadvantage on small-cap index funds (for example, Russell 2000) of 190 basis points (1.90 percent). Other numbers in Figure 9.2 reflect expected differences in fund-management expense ratios, which may be slightly higher for a silent index fund's ETF share class. (The premium expense ratio may be justified by the expectation of premium fund performance based on savings in transaction costs with silent indices.) It's reasonable to assume in Figure 9.1 that the new index ETF share classes will face relative transaction cost penalties...

Myth 5 indexing pushes Up the market

The charge here is that the popularity of indexing the S& P 500 led to extreme valuations, especially relative to small-cap stocks. The theory is that indexing the S& P 500 is a self-fulfilling prophecy. Companies that are added to the S& P 500 experience price spikes as passive investors necessarily snap up shares. In other words, added companies get pricier simply because they are index members, not because of fundamental economic reasons. As financial advisor Larry Swedroe pointed out on, the idea doesn't hold water. One study in the area was conducted in 1998 by Melissa Brown, former head of quantitative research at Prudential Securities. Contrary to popular belief, the proportion of S& P 500 Index fund assets declined from 6.7 in 1992 to 6.1 in 1997. The funds grew from 255 billion to 600 billion, but the rest of the market also grew. Similarly, Brown noted that there was a net outflow of investor capital. If all investors had kept their money in the...

Exploring Smallcaps and Speculative Stocks

Everyone wants to get in early on a hot new stock. Why not You buy Shlobotky, Inc., at 1 per share and hope it zooms to 98 before lunchtime. Who doesn't want to buy a stock that could become the next IBM or Microsoft This possibility is why investors are attracted to small-cap stocks. Small-cap (or small-capitalization) is a reference to the company's market size. Small-cap stocks are stocks that have a market value under 1 billion. Investors may face more risk with small-caps, but they also have the chance for greater gains. Out of all the types of stocks, small-cap stocks continue to exhibit the greatest amount of growth. In the same way that a tree planted last year has more opportunity for growth than a mature 100-year-old redwood, small-caps have greater growth potential than established large-cap stocks. Of course, a small-cap doesn't exhibit spectacular growth just because it's small. It grows when it does the right things, such as increasing sales and earnings by producing...

If its a smallcap stock make sure its making money

These points are especially important for investors in small stocks. Plenty of start-up ventures lose money but hope to make a fortune down the road. A good example is a company in the biotechnology industry. Biotech is an exciting area, but it's esoteric, and at this early stage, companies are finding it difficult to use the technology in profitable ways. You may say, But shouldn't I jump in now in anticipation of future profits You may get lucky, but understand that when you invest in unproven, small-cap stocks, you're speculating.

Market Inefficiencies and Money Manager Performance

There are a number of possible explanations. The most benign one is that the inefficiencies show up mostly in hypothetical studies and that the transactions costs and execution problems associated with converting these inefficiencies into portfolios overwhelms the excess returns. A second possible explanation is that the studies generally look at the long term - many are over 20 to 50 years. Over shorter periods, there is substantially more uncertainty about whether small stocks will outperform large stocks and whether buying losers will generate excess returns. There are no investment strategies that are sure bets for short periods. Pradhuman (2000) illustrates this phenomenon by noting that small cap stocks have underperformed large cap stocks in roughly one out of every four years in the last 50 years. Bernstein (1998) notes that while value investing (buying low PE and low Price to book value stocks) may earn excess returns over long periods, growth investing has outperformed...

Investing in smallcap stocks requires analysis

The only difference between a small-cap stock and a large-cap stock is a few zeros in their numbers and the fact that you need to do more research with small-caps. By sheer dint of size, small-caps are riskier than large-caps, so you offset the risk by accruing more information on yourself and the stock in question. Plenty of information is available on large-cap stocks because they're widely followed. Small-cap stocks don't get as much press, and fewer analysts issue reports on them. Here are a few points to keep in mind 1 Understand your investment style. Small-cap stocks may have more potential rewards, but they also carry more risk. No investor should devote a large portion of his capital to small-cap stocks. If you're considering retirement money, you're better off investing in large-cap stocks, Exchange-Traded Funds (ETFs), investment-grade bonds, bank accounts, and mutual funds. For example, retirement money should be in investments that are either very safe or have proven...

Did you ever meet Peter Lynch

Whereas the Gap is continually changing with the times and getting in fresh inventories that meet their customers' needs. Does that imply that you bought the Gap and shorted Bombay We don't trade the Gap because we only trade small cap stocks. We have been short Bombay from time to time. What are examples of trades that were largely inspired by mall visits

Appendix Core and Satellite A Live Example

Broad domestic core* Large mid cap domestic value Small cap domestic value International developed Micro cap domestic growth Emerging markets Alternative Small cap domestic value 4 The core allocations reflect the firm's philosophy of modest overweighting in value and small-cap positions to capture BtM and size factors and its belief that nondomestic positions should be incorporated in a core portfolio. The determination of the percentage of the allocations is based on a classic Markowitz mean-variance optimization, constrained and then tested for acceptable suboptimal performance (that is, OpSop, Evensky 1997 ). The rebalance parameters are absolute percentages and are set based on a number of factors, including the standard deviation of the asset class, the size of the commitment to the class, and the estimated correlation between investments. 7. Large, mid-, and small capitalizations growth, core, and value styles.

Capacity and Liquidity

Stocks, as they were in the late 1990s, cap-weighted indexes will overweight the large-cap stocks, whereas fundamentals-based indexes, blissfully ignorant of these valuation multiples, will not. The result is that in late 1999, the RAFI U.S. Large had approximately half of the average capitalization of the Russell 1000, still with a hefty enough dose of large-cap companies to make it scalable. By the end of 2006, small-cap stocks were trading at a premium. The RAFI U.S. Large rescaled these stocks down to their economic scale, leading to an average market capitalization slightly higher than the Russell 1000 in effect, the RAFI U.S. Large sometimes will exhibit a large-cap tilt We'll come back to the myth of the small-company bias of the Fundamental Index portfolios in Chapter 10.

Asset Allocation An Investment Recipe

You may hear a mutual fund nerd spout off about his allocation between large-cap and small-cap stocks, or between growth funds and value funds. Don't worry about these terms for now (for the nerd in you, you'll be happy to know that I cover these other fund subcategories in Chapter 9). Even after you finish reading this book and become a mutual fund hotshot, you should be mostly concerned with the general asset allocation decisions namely, allocating between stocks and bonds, and between U.S. stocks and international stocks.

How to Improve the Meaningfulness of Performance Measurement Tools

Performance tools are especially robust when they confirm a priori expectations regarding the quality of returns. If we can identify a disciplined and effective process, we should expect that the process will generate superior risk-adjusted returns. The tools provide a means of measuring the extent of the process's effectiveness. The tools should confirm our belief that the process is indeed functioning the way it was designed to. For example, risk decomposition analysis should show that small cap managers are in fact taking most of their risk in small cap themes. Similarly, a manager with a particular industry specialization should be able to demonstrate that most of that risk budget is spent in securities in that industry. And so on.

Thats right I just put in the orders What was the next step in your career progression

I left with Henry and helped him start the office for his new firm. I did research and trading for him for two years. Although it was a good experience, I realized my future was limited, since Henry was not willing to give up much control over the portfolio. Around the time I decided that I had to leave, my husband got a good job offer in another city, and we decided to move. I found a job at Atacama Investment, which at the time was an institutional money management firm. I started out as a portfolio manager, comanaging their small cap fund a fund that invests in companies with small capitalization , which had a couple of billion dollars in assets. Had you had any experience before

How Do Etfs Work In Risk Management Applications

Existing ETFs are all based on benchmark indices. While there are important benchmarks and there are unimportant benchmarks, benchmark index derivatives are widely used in risk management applications. For example, an investor with an actively managed small-cap portfolio might feel that superior stock selection reflected in the portfolio will provide good, relative returns over the period ahead, but that most small-cap stocks might still perform poorly. The investor can hedge the portfolio's exposure to small-caps while capturing its stock selection advantage by hedging the small-cap risk with a short position in a financial instrument linked to the Russell 2000 small-cap benchmark index. Available risk management tools for this application range from futures contracts and equity swap agreements to the shares of a small-cap exchange-traded fund.

Turtle Trader comment Got that Buy and hold but be ready to sell

On to my first episode in small-cap investing the story of how the perfect sell presented itself to me and how I ignored it. The stock market, patient though it sometimes can be, is not merciful forever. Eventually, it took back the money that it had let me think was mine.

Figure 75 Active Managers in Small Cap versus Benchmark Ending May 31 2007

Index by 1.8 percentage points annually over the 10 years ended May 31, 2007. The ground in the small-cap domain is arguably more fertile for active managers than it is in the large caps. It is very important to note that these managers were the survivors over the past 10 to 15 years. Presumably, most of the funds that failed were underperformers, so this picture is probably somewhat too rosy.

Forward Versus Backwardlooking Risk

The relative volatility of different investments is a major factor in our investing decisions. Past volatility is used as a proxy for absolute risk in several ways. We use measures of historical volatility to estimate future volatility. For example, based on the historical returns, we can see that we might not be too confident in earning around 17 in any one year in small company stocks, even though that is our long-term average return. We would be progressively more confident in achieving the average return to other asset classes. This confidence comes in exchange for a lower long-term average return. Historical volatility also informs our estimate of the probability of experiencing a short-term loss. We have a higher probability of losing money in any one year in an asset class with a wider dispersion of returns than one with a smaller dispersion.

Cost of Equity and a Small Firm Premium

In chapter 6, we presented evidence of a small firm premium - small market-cap stocks earn higher returns than large market-cap stocks with equivalent betas. The magnitude and persistence of the small firm premium can be viewed as evidence that the capital asset pricing model understates the risk of smaller companies, and that a cost of equity based purely upon a CAPM beta will therefore yield too low a number for these firms. There are some analysts who argue that you should therefore add a premium on to the estimated cost of equity for smaller firms. Since small cap stocks have earned about 2 more than large cap stocks over the last few decades, you could consider this a reasonable estimate of the small firm premium. To estimate the cost of equity for a small cap stock with a beta of 1.2 (assuming a riskfree rate of 5.1 and a market risk premium of 4 ), for instance, you would do the following Cost of Equity for small-cap stock Riskfree Rate + Beta * Market Risk Premium + Small Cap...

Powershares International Dividend Achievers Fund

One new portfolio, Euro Currency Trust, began trading on Dec. 12. It lets investors bet on the euro, with each share of the etf representing 100 euros. Expect a slew of new offerings in 2006, say analysts. But India is one country that has proved to be a tough nut to crack. The country's capital markets are notoriously difficult to emulate with a single market index because of the large number of small-cap issues there. An ETf sponsor ought to address that in 2006, says Morgan Stanley ETf analyst Paul Mazzilli. We get inquiries about it all the time, he says. With the MSCi India Index up 35 in 2005 through Dec. 9, it's no wonder. II

Targeting The Analysts

Small-Cap, Mid-Cap Baron Capital manages the Baron family of mutual funds, as well as separate equity portfolios. The firm is primarily a small mid-cap theme-oriented investor that looks for stocks with growth characteristics with a value orientation. Baron defines small-cap as those with market caps between 100 million and 1.5 billion and mid-cap stocks as those with market caps between 1.5 billion and 5 billion.

Value Approach to Investing

Wally typically focuses on mid-sized companies. The average market capitalization of stocks in his fund is currently around 6.5 billion. Occasionally he will venture into the micro-cap world, but rarely. For example, he currently has a position in Intellegent Systems, an 8.5 million market-cap company. I know management well and I like them, he says. The stock sells around a buck and a half, but I think it could go to 4 or 5. But this is not the typical micro-cap company selling at an attractive price.This one has promise. Many others selling at attractive prices are what I call 'permacheaps'because of their lackluster fundamentals

The Inside Investor

Almost all of the high returns are found in the small microcap stocks with market capitalizations below 25 million. The down side is that these stocks are too small for mutual funds to invest in and hard to find for the average investor. As O'Shaughnessy states, tantalizingly out of reach of nearly everyone. There is very little trading volume in these stocks so the ask price and bid price are usually far apart. This is an example of how 10 of the investors gain control of 90 of If you can't find these stocks to invest in, then consider the next best thing. Build your own small cap stock company and enjoy the superior returns as the inside investor.

Factor Mimicking Portfolios

Factor returns generated from the cross-sectional regressions presented above are often described as returns to factor-mimicking portfolios. The term factor-mimicking portfolio comes from the idea that a portfolio of assets can be constructed in such a way that its behavior emulates the behavior of some factor. This portfolio is known as a long-short portfolio. A long-short portfolio consists of nearly equal amounts of long and short positions. Together, these positions have the ability to mimic particular factors. For example, a portfolio that consists of long positions in large-cap stocks and short positions in small-cap stocks is said to mimic the size factor. Large positive returns on such a portfolio show that large-cap stocks outperform small-cap stocks.

How indexes are Constructed

An equally-weighted index makes no distinction between large and small companies, both of which are given equal weighting. Since there are many more small companies than large ones, this strategy greatly emphasizes small companies relative to their economic activity. Table 15.2 is an index of two stocks constructed with each method shows how overweighting of high-priced stocks occurs in price-weighting and how overweighting of small-cap stocks occurs in the equally-weighted index.

Market Capitalization

What comprises a small-cap company The answer will vary widely depending upon who you ask and the universe of stocks that they invest in. For an investor who restricts his investments to S& P 500 companies, a billion dollar company may be a small company. For an investor who looks at smaller stocks on the NASDAQ, the cutoff will be much lower. It will also shift as the market goes up and down. At the peak of the stock market in 1999, there were dozens of companies trading at market capitalizations that exceeded 100 billion. In 2002, after three years of a bear market, there were only a handful left. Note the extraordinary number of firms (more than 1200) that had market capitalizations that were less than 5 million. This represents the convergence of two phenomena - the large number of small companies that went public in the 1990s and the dramatic fall in value at these companies as the technology bubble burst. In fact, you can safely argue that a large number of the smallest...

Equity Long Short Strategies

Hedge fund managers tend to attribute the returns on their portfolios to their own stock picking and trading abilities. Undoubtedly, manager skill contributes to the returns on an equity long short strategy (especially as it relates to small capitalization stocks), but returns are at least partially attributable to risk premia observed in global equity markets. Long short managers buy undervalued stocks (often small capitalization) and sell overvalued stocks (often large capitalization) during overall rising markets, indicating exposure to risk premia associated with value stocks, small cap stocks, and the broad market. In other . words, long short managers take on risks related to these areas of the market, just as other investors take on these risks. Therefore a portion of the returns earned by the long short manager is simply the reward expected for taking on certain systematic risks. However, the delineation between returns attributable to manager skill and returns due to risk...

Important for Bulls Bears

If you're 35 and heading into your peak earnings years and want to ride a home-run stock, and you understand the risks, then go ahead and speculate with that small-cap gold mining stock or the solar power technology junior stock. If you're aggressive and bullis you want to buy the stocks directly. For real growth potential, look at mid-caps or small-caps. Remember that you're speculating, so you understand the downside risk but are willing to tolerate the risk because the upside potential can reward you so handsomely. Few things in the investment world give you a better gain than a super-charged stock in a hot sector.

Who Issues Convertibles

Convertibles are issued by both small cap and large cap firms although small cap firms are general candidates. Twenty percent of the S& P constituents have convertibles outstanding. Among the large companies AIG, AIG Berkshire Hathaway, UPS, General Motors, and Ford have issued. Among growth firms Amgen, Genzyme, Nortel, Lucent, Yahoo, and Computer Associates have issued. Convertibles are also issued by companies undergoing restructuring.

Popularity of an index

This is also true of small-cap U.S. indexes, which tend not to move in lockstep with better publicized large-cap indexes such as the Dow Jones Industrials. Although many believe indexes are created in an entirely mechanical manner, this is not true. The Dow Jones Industrials and many S& P indexes, to name a few, are created by committee vote of internal editors. This can be a good thing. Consider the case of small caps, where the most popular index is probably the Russell 2000, an index created in automated fashion once a year without discretion. According to Goldman Sachs, the S& P Smallcap 600 outperformed the Russell 2000 by 47 during the period January 1994 to March 2002 Yet the indexes remained highly correlated at around 0.97 during that period, according to Goldman Sachs. How could two indexes that directionally move in lockstep be so far apart

An Eclectic Philosophy

Eclectic is the word Jeff uses to define his early investment philosophy.We were really trying to pursue companies that were undiscovered by Wall Street, he says, though we had some companies in the portfolio that predated me, such as Pepsi.Within two years, as money was brought in and Jeff's investment philosophy was more finely tuned, we were pretty much investing in undiscovered, growth-oriented small-caps that had potential for big earnings growth. Jeff feels that his interest in small-caps can be traced back to the days he watched his father build his small title company. It made me realize that the owners of small-cap companies

Portfolio Selection An Example

These inputs are an example of estimates that are not totally based on historical performance of these asset classes. The expected return estimates are created using a risk premium approach (i.e., obtaining the historical risk premiums attached to bonds, large-cap, mid-cap, small-cap, and international equity) and then have been subjectively altered to include the asset manager's expectations regarding the future long-run (5 to 10 years) performance of these asset classes. The risk and correlation figures are mainly historical. U.S. small cap equity

Example 82 Style Analysis Correlations

Suppose a portfolio manager uses small-cap stocks in an investment portfolio. By applying style analysis, we can try to determine whether the portfolio manager uses a small-cap growth style or a small-cap value style. In the United States, the Russell 2000 Growth Index and the Russell 2000 Value Index are often used as benchmarks for small-cap growth and small-cap value managers, respectively. Correlation analysis shows, however, that the returns to these two indexes are very closely associated with each other. For the 20 years ending in 2002 (January 1983 to December 2002), the correlation between the monthly returns to the Russell 2000 Growth Index and the Russell 2000 Value Index was 0.8526. If the correlation between the returns to the two indexes were 1, there would be absolutely no difference in equity management style between small-cap value and small-cap growth. If we knew the return to one style, we could be certain about the return to the other style. Because the returns to...

Growth Versus Value Investing

Among those growth funds, there are different targets in investing. Some specialize in large-cap companies others invest in mid-cap or small-cap. For example, Fidelity Blue Chip Growth Fund invests in large capitalization, above-average growth potential companies similar to those that make up the S& P 500 or Russell 1000 indexes. There are also so-called mid-cap growth funds that focus on mid-cap stocks with above average growth. Finally, most people associate growth with small-cap stocks. Small-cap funds invest in common stocks of small-cap companies that exhibit above average growth characteristics.

Example 83 Exchange Rate Return Correlations

In the next example, we extend the discussion of the correlations of stock market indexes begun in Example 8-2 to indexes representing large-cap, small-cap, and broad-market returns. This type of analysis has serious diversification and asset allocation consequences because the strength of the correlations among the assets tells us how successfully the assets can be combined to diversify risk.

TABLE 84 Correlations of Monthly Returns to Various US Stock Indexes

Small stocks also have a reasonably high correlation with large stocks. In the total sample, the correlation between the S& P 500 returns and the U.S. Small-Stock returns is 0.7615. The correlation between U.S. Small-Stock returns and returns to the Wilshire 5000 is slightly higher (0.8298) This result is also not too surprising because the Wilshire 5000 contains small-cap stocks and the S& P 500 does not. The second, third, and fourth panels of Table 8-4 show that correlations among the various stock market return series show some variation from decade to decade. For example, the correlation between returns to the S& P 500 and U.S. small-cap stocks dropped from 0.8440 in the 1980s to 0.6843 in the 1990s.11

Figure 104 Average Weighted Capitalization for Rafi Us Large Russell 1000 and SP 500

Classic cap-weighted indexes), thereby creating a small-cap tilt relative to the cap-weighted market. But one could as easily say that the market has a large-cap tilt relative to the economy. When the markets assign higher valuation multiples to small companies, as they did in the United States in 2007, the Fundamental Index portfolio, because it is valuation indifferent, invests less in these stocks than do the cap-weighted indexes, leading to a larger-cap profile for the Fundamental Index portfolio. Only in rare instances, when large-cap and small-cap companies command starkly different valuation multiples, will the size profile of the Fundamental Index portfolio materially diverge from a relatively confined range. At the peak of the tech bubble, the average weighted market capitalization of the RAFI U.S. Large was 62 billion, roughly half that of the Russell 1000. The reason for this gap is simple. The market was paying an immense premium to some of the era's highest-priced (hence...

Toro Approaching a bull market

This choice reflects your risk tolerance as well. Figure out whether you want to invest in a small-cap stock with phenomenal growth prospects (and commensurate risk) or a large-cap stock that's a tried-and-true market leader. All things being equal, small-cap stocks exhibit the best growth performance in an emerging bull market. Small-cap stocks are more appropriate for investors who have a higher risk tolerance. Of course, most stocks do well in an emerging bull market (actually, that's what makes it a bull market ), so even risk-adverse investors who put their money into larger companies will gain. (For more information on growth stocks such as small-caps, see Chapter 8.)

Example 86 Correlations among Net Income Cash Flow from Operations and Free Cash Flow to the Firm

13 The results in this table are based on data for all women's clothing stores (U.S. Occupational Health and Safety Administration Standard Industrial Classification 5621) with a market capitalization of more than 250 million at the end of 2001. The market-cap criterion was used to eliminate microcap firms, whose performance-measure correlations may be different from those of higher-valued firms. We will discuss in detail the data normalization used in this example (dividing by firm revenue) in the section on misspecified regressions in Chapter 9.

Fama and French Factors

The value and size effects were exquisitely documented by Eugene Fama and Kenneth French in their Journal of Finance masterpiece (1992). They found that, in addition to broad market exposure, exposure to value stocks and small-cap stocks increases a portfolio's expected return. That is, diversified portfolios of value stocks and small-cap stocks can earn more than a large-cap portfolio of similar market beta Fama and French subsequently posited that value and small-cap exposure must be substantially more risky than what is suggested by their market betas (as measured by the CAPM). After all, in a rational and efficient market, additional return can be had only through taking on more risk. Critics of the Fundamental Index strategy argue that the RAFI concept does not create economically significant alpha it just takes on more value and small- cap risk. If so, the Fundamental Index strategy is nothing new. It is just a way of embedding value and small-cap exposure into a portfolio in an...

Some Big Surprises in Small Companies

If the Fundamental Index strategy is just the result of value and size tilts, we might expect to see even greater value and size bets in the Fundamental Index strategies that generate the largest alphas. We'd be wrong The RAFI U.S. Small, which comprises the 2,000 companies ranked from 1,001 to 3,000 by the fundamental measures of size, provides a good test of this contention. From 1979 through 2007, returns of the RAFI U.S. Small exceeded the returns on the small-cap benchmark Russell 2000 by 340 basis points annually. Moreover, it did so with larger companies than the Russell 2000 and a surprisingly modest value tilt, on average. At any point in time, there are scores of these high-multiple stocks (like All of them raise the average capitalization of the RAFI U.S. Small higher than the comparable Russell 2000. These high- multiple, small- company stocks also largely offset the natural value tilt of the Fundamental Index portfolio. In fact, at times, the RAFI U.S....

Practical Considerations

Most funds also have multiple share classes in different currencies, allowing the investors the benefit of hedging against adverse currency moves. U.S. investors want the dollar share class if available. Outside the top 10 funds, which are fairly liquid, the average fund has a 2 bid ask spread. Investors must be careful and use limit orders when purchasing shares in these funds the same way they would trade small and micro-cap stocks here in the United States.

Living the bachelor life Young single with no dependents

Consider a mix of small-cap, mid-cap, and large-cap (see Chapter 1 for an explanation of each of these stocks) growth stocks in growth industries. Invest some of your money in five to seven stocks and the remainder in growth-stock mutual funds. You can revise your investment allocations along the way as the general economy changes and or your personal situation (like when you finally say I do to the love of your life) changes.

Proof Statement in 2007

In 2007, the markets rewarded growth and punished value all over the world. Small companies were especially hard-hit. Growth beat value by an impressive 12 percentage points in U.S. large-cap companies, by 10 percentage points in developed non-U.S. markets, and by a whopping 17 percentage points in U.S. small-cap companies. Large-cap beat small-cap by 7 percentage points in the United States and by 10 percentage points in developed non-U.S. economies.

Historical Rate of Return

Table 9.1 shows the performance of private equity funds up to December 31, 2000, over five different time periods. The returns can vary quite a bit from year to year, but our feeling is that, because this is a long-term investment strategy, investors should focus on the 5- to 20-year returns rather than on the volatile 1-year returns. When the public markets are strong and stock indexes, such as the NASDAQ Composite and Russell 2000 Index of small-cap companies, are at high levels, IPOs are met with enthusiasm and values of companies going public are high. For example, the year 1999 had some record IPO prices for companies going public in the telecommunications, Internet, and other technology areas.

Real estate investment trust funds

W _ w REITs are small-company stocks and usually pay decent dividends. As such, they are not appropriate for higher-tax-bracket investors investing money outside of retirement accounts. Most of the larger, diversified U.S. stock funds that I recommend earlier in this chapter have a small portion of their fund's assets invested in REITs, so you'll have some exposure to this sector with investing in a REIT focused fund.

Recovery Rates by Seniority

The table below gives data on the monthly returns on the S& P 500 and small-cap stocks for the period January 1960 through December 1999 and provides statistics relating to their mean differences. Small-Cap Stock Return ( ) Differences (S& P 500 - Small-Cap Stock) Let xd stand for the population mean value of difference between S& P 500 returns and small-cap stock returns. Use a significance level of 0.05 and suppose that mean differences are approximately normally distributed. A. Formulate null and alternative hypotheses consistent with testing whether any difference exists between the mean returns on the S& P 500 and small-cap stocks.

No 4 Core and Explore

The explore portion can certainly include the popular international, small-cap, and value classes. Sectors, REITs and other individual plays are also popular and perfectly reasonable. It is assumed as well that part of the portfolio remains in bonds. In Table 16.4 we present a portfolio that overweights small-cap and value asset classes only because this portfolio has proven so popular in the indexing community.

How Much Of A Good Thing Do You Want

Almost every book on investing talks about asset allocation how much of your portfolio should be in stocks (both domestic and international, large cap and small cap, growth and value), how much in bonds, how much in real estate, and how much in cash. Some experts say that as you get older you should shift more into bonds and have less in stocks in order to reduce risk, while others recommend that your asset allocation be adjusted according to the investment environment or one's tolerance for risk and volatility. Who's right

Portfolio Construction

Models comprising the investment process employ the same techniques that a solid, fundamental investor uses in selecting stocks.They have 500 to 600 stocks, on average, in each U.S. small-cap portfolio, and each one is selected based on its current relative value and earnings potential. And they are quick to sell stocks as soon as they reach fair value, with no second thoughts. Turnover of stocks within a portfolio is about 100 percent per year.

Fixed Mix And Strategic Asset Allocation

Fixed mix strategies, in which the asset allocation weights are fixed and the assets are rebalanced at each decision point to the initial weights, are very common and yield good results. An attractive feature is an effective form of volatility pumping since they rebalance by selling assets high and buying them low. Luenberger (1998) presents a general discussion of the gains possible from volatility pumping. Fixed mix strategies compare well with buy and hold strategies see, for example, Figure 21.1 which shows the 1982 to 1994 performance of a number of asset categories including mixtures of EAFE (Europe, Australia and the Far East) index, S& P500, bonds, the Russell 2000 small cap index and cash.

The Impact of Portfolio Size Benchmark Volatility and Portfolio Beta on Tracking Error4

Capitalization portfolio benchmarked to the S& P 500, a mid-cap portfolio benchmarked to the S& P 400, and a small cap portfolio bench-marked to the S& P 600.5 Notice that an optimally chosen portfolio of just 50 stocks can track the S& P 500 within 2.3 . For mid cap and small cap stocks, the corresponding tracking errors are 3.5 and 4.3 , respectively. In contrast, tracking error increases as the portfolio progressively includes more stocks that are not in the benchmark. This effect is illustrated in Exhibit 19.3. In this case, the benchmark index is the S& P 100 and the portfolio progressively includes more and more stocks from the S& P 500 that are not in S& P 100. The result is that the tracking error with respect to the S& P 100 rises.

Regulation D Strategies

Securities Act of 1933 allows public companies to raise capital through private placements of unregistered securities. Private placements are cheaper and less time consuming than public issuances of securities and are thus an attractive alternative. In a Regulation D strategy, a hedge fund manager takes a long position in privately placed unregistered securities (stocks, convertibles, options, or warrants) issued by a publicly traded small or micro capitalization company. Hedge fund managers pursuing Regulation D strategies utilize their specialized knowledge of Regulation D issuances in conjunction with their ability to negotiate and successfully manage the private placement to generate alpha for investors. Since Regulation D strategies involve small and micro capitalization companies and private securities, information inefficiencies exist that allow for potentially high returns from mispricings. However, a portion of the returns to Regulation D strategies...

Equity Style Management

Before we discuss the various types of active and passive strategies, let's discuss an important topic regarding what has come to be known as equity investment styles. Several academic studies found that there were categories of stocks that had similar characteristics and performance patterns. Moreover, the returns of these stock categories performed differently than other categories of stocks. That is, the returns of stocks within a category were highly correlated and the returns between categories of stocks were relatively uncorrelated. As a result of these studies, practitioners began to view these categories of stocks with similar performance as a style of investing. Using size as a basis for categorizing style, some managers became large cap investors while others small cap investors. (Cap means market capitalization.) Moreover, there was a commonly held belief that a manager could shift styles to enhance performance return.

No 8 Big is beautiful

Over longer periods large-caps do not, however, appear to keep up with small caps. In addition, they have sustained run-ups compared to smaller stocks every decade or two. In the early 1970s the Nifty Fifty largest stocks delivered splendid returns relative to small stocks was nearly vaporized, and this happened again to a lesser extent in the late 1990s. In both markets this occurred hand-in-hand with the overvaluation of growth. Large stocks and growth stocks seem to gather momentum during the frothiest markets. This bit of information is by no means helpful for prediction, but the commonsense investor is encouraged to keep it in mind (see Table 16.9).

New and Improved Market Systems

The demand for these stocks drove their prices up and attracted more money. Thus, an alternative to seasoned equities evolved for institutional investors. The dramatic increase in microcap investing among the professional investors raised the question about whether the historical risk return relationships were still appropriate for measuring the performance of these particular equities.

Revisiting The Research

Banz at the University of Chicago began studying the returns of stocks based on their market capitalization. His research suggested that, even after adjusting for risk, small company stocks seemed to do better than the stocks of large companies. Banz and Marc R. Reinganum subsequently published papers in the March 1981 issue of the Journal of Financial Economics1 2 that argued that those stocks in the smallest cap CRSP deciles generated returns more than 5 percent higher than returns of the larger cap stocks over the same periods. They construed this excess return as the risk premium for holding the smaller capitalized stocks. This observation was discussed among academics in the context of the Capital Asset Pricing Model (CAPM) and became known as the size effect.

Special Issues That Women Face

Equity Market Neutral buying stock selling borrowed stock to maintain a portfolio net exposure of zero dollars, zero beta, or zero sector no market direction bets. Event-Driven buying stock & or selling borrowed stock OR in synch stock purchase with sale of borrowed stock & or convertible bond of firm expected to have one of these events 1) Risk (Merger) Arbitrage merger or acquisition 2) Distressed or High Yield Securities financially distressed or bankrupt company 3) Regulation D micro small cap public firm raising private monies. Fixed Income Arbitrage buy interest rate security sell borrowed related interest rate security on a global basis. Global Macro buy any (including derivative) asset sell borrowed same asset on a global basis based on an opinion of overall market direction in reaction to economic event.

Revisiting The Diversification Argument

Microcap enthusiasts argue that most microcap stocks are inefficiently priced almost all the time therefore, they reason that these stocks provide real diversification in a stock portfolio of different market caps. This presupposes some significant variance in market performance from the larger cap stocks. Is there any evidence of this for just microcap growth stocks How valid is the evidence over several market cycles and macroeconomic cycles Does past performance guarantee anything, particularly in the light of recent regulations governing financial disclosure and dictating trading procedures For the 30-year period ending December 30, 2000, small company stocks (CRSP deciles 6 through 10) returned 150 basis points over the stocks of the large companies (CRSP deciles 1 through 5), including reinvested dividends but not before transaction costs. One can therefore infer that the absolute returns difference could be negligible. There is almost no research available on what caused this...

The Small Company Blues

The beginnings were highly principled. Two young Ph.D. candidates at the University of Chicago, Rolf Banz and Marc Reinganum, were engaged in the lofty cause of defending the efficient market hypothesis in the late 1970s when it was initially challenged by the findings of the low P E strategy. The two wrote their Ph.D. theses on the validity of the small-cap effect. Some of the leading figures of efficient markets, including Eugene Fama, Roger Ibbotson, and Myron Scholes, sat on their dissertation committees. Here's where the myth got its first academic blessing. Rolf Banz proved that small stocks outperformed large companies over time. Mark Reinganum concluded that there was no low P E effect rather it was a small-cap effect. Without the small stock effect, low P E stocks did not beat the market. The Banz findings did not pertain to small caps at all, since he used as a sample all the companies on the New York Stock Exchange (NYSE). Back in the late 1920s when his study began, and...

We Have a Tiein to Mecca

What advocates of small-cap stocks may have lacked in research, they made up in chutzpah. Take Rex Sinquefield, who coauthored with Ibbotson. He became one of the founding partners in Dimensional Fund Advisors, a firm formed in late 1980 to take advantage of the small-cap effect. On the board or serving as advisors were ten high-powered University of Chicago professors or alumni, including Roger Ibbotson, Eugene Fama, Merton Miller, Myron Scholes, and Rolf Banz.9 Sinquefield, when asked what he thought of active portfolio management, sneered, crap.10 Sinquefield was hyping his new small-cap product at the time, whose hype naturally included the spectacular performance I questioned above. * The most commonly used index to measure small-cap performance. Still, give credit where credit is due. The marketing of the product, and the founding of a major investment firm, Dimensional Fund Advisors (DFA), on it could make a case study at the Harvard Business School, even if the academic work...

Where Are the Market Makers

The SEC issued a new set of rules in 1997 that changed the way orders were handled by the Nasdaq systems. The rules were intended to correct some practices that were allegedly increasing investors' trading costs. After the new rules were implemented, securities dealers who had provided the liquidity with their trading desks soon discovered that it was impossible to make any money trading the smallest of caps under the new rules. These securities dealers subsequently shut down their trading operations and ceased making retail markets in the Nasdaq Small Cap Issues system. There is now an oligopolic structure standing astride the Nasdaq Small Cap Issues system that is not providing the necessary liquidity for that system's listed stocks. Investment bankers who underwrite IPOs that would have been listed on the Small Cap Issues system are now arranging to have those stocks listed on the AMEX. There also have been many instances wherein companies have left the Small Cap System for the...

Answers Concept Checkers

Suggesting that his sample or sample period is necessarily small. The most likely problem here is one of nonsynchronous trading. For stocks that trade infrequently, market closing prices may be those from trades many hours earlier and the opening trades the next day may come many hours after the opening. The problem, then, is that he is measuring volatility over a potentially much longer period for the small-cap stocks than for the large-cap stocks that likely trade near both the close and the opening.

Should You Give Up on Small Stocks

Reinganum, as we saw, attempted to dismiss the low P E findings as a small-cap effect. Nothing could be further from the truth, as Table 15-1 indicates. The study, from 1970 to 1996, is an update of one I published in Forbes on July 23, 1990. It shows two important investment findings. First it demonstrates that there is a low P E effect regardless of the size of the company. Secondly it shows a definite small-cap effect, which results in superior returns to smaller companies but this effect Small Cap or Small Low P E 1970-1996

Small Cap Contrarian Rules

Small-cap investing Buy companies that are strong financially (normally no more than 60 debt in the capital structure for a manufacturing firm). Small-cap investing Buy companies with increasing and well-protected dividends that also provide an above-market yield. Small-cap investing Pick companies with above-average earnings growth rates. Small-cap investing Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one. Small-cap investing Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous. What we see clearly is that the small-cap and low P E effects are separate. Buying small companies does give you higher returns, but only if you select low P E stocks.14 The low P E effect continues to be strong regardless of the size of the company. Even buying the largest group, the return on the lowest P E quintile is...

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