Beyond the S&P 500
Last week, we wrote about the flood of investor money into the S&P 500 index and our concerns about the increasing divergence in valuations between the S&P 500 and everything else. We suggested that investors looking for alpha opportunities should look beyond the S&P 500 to smaller-cap stocks and international stocks, where valuations are significantly lower.
But there’s an obstacle to implementing that advice. You can’t run multi-billion-dollar hedge funds or ETFs that have meaningful exposure to the cheapest small and international stocks because the best opportunities are economically insignificant to large asset managers. Because most stocks in all developed markets are small, as you increase your assets under management, you rapidly decrease your selection opportunity and increase the prices you pay.
The vast majority of stocks are small. Below is a picture of the three biggest developed markets, showing all stocks above $25 million in market capitalization. All three markets have about 3,000-4,000 stocks with about 70% of the market made up of stocks below $2 billion in market cap in the US and 70% below $1 billion in Japan and Europe.
Figure 1: Size Distribution of All Stocks by Geography1
Building a meaningful portfolio of these small stocks grows more challenging as AUM increases. Funds need to eliminate stocks that are too small to be tradeable. And the bigger stocks left over generally have higher valuations. Below we show what percentage of all stocks a fund could invest in at a given AUM in a simple 100-stock equal-weighted portfolio, and the price/book premium for the stocks that are still investable at each AUM level.
Figure 2: Selection Opportunity and Premium Paid by AUM1
Funds have fewer selection opportunities as AUM increases, and they have to pay higher prices. Investment vehicles above ~$250 million in Japan and Europe and $1 billion in the US would exclude about half of the investible universe and would pay about 10% more for what’s left over relative to an investment vehicle at $50 million.
Andrew Lapthorne, the head of quantitative research at Société Générale, says that this is an increasingly important phenomena to understand. “The cost of adding a standard liquidity filter to systematic value portfolio takes about 4-5% off your returns,” he wrote. “In a world of double digit returns this didn’t matter so much, in a world of single digit returns, illiquidity represents an opportunity.”
Lapthorne’s point is particularly relevant to value investors, who are seeking to buy the cheapest 10% or 25% of the market. Below is the percentage of each total stock market that meets the criterion of value and deep value (25th percentile and 10th percentile cheapest in the whole market) that is left over after the volume constraints are ratcheted up to accommodate more AUM. We greyed out the numbers where there weren’t even 100 qualifying stocks, as such a portfolio would be logically impossible given the market’s structure.
Figure 3: Elimination of Value Opportunities as AUM Increases1
At the level of AUM at which most funds operate, it is very hard to achieve portfolios with undiluted exposure to the value premium because of the paucity of qualifying stocks in each market.
But it gets even worse! Even when you technically meet these academic value thresholds, you are still paying higher prices as AUM scales. Below is the average price/book ratio and premium a fund would pay relative to the “no-constraints” portfolio within remaining opportunity sets:
Figure 4: Price-to-Book and Price Increase of Qualifying Value Opportunities at Varying AUM1
And this is not some transient phenomenon. Across all three markets, valuations have been correlated with size/volume with remarkable persistency. Here is the last 20 years by price/book for the whole US market by decile of size each year:
Figure 5: Persistency of Size and Value Correlation over Time1
We’ve found remarkable consistency (here and here) of return degradation among all permutations of concentration and minimum volume by AUM. And value-weighted premiums are materially lower than equal-weighted premiums for most all robust quantitative factors. Despite this, Morningstar’s US “Small Value” mutual fund vehicles with 4- or 5-star ratings have an average of $2.4 billion in AUM: far too large to take advantage of the value premium.
Running a value strategy entails many sacrifices. But the most frequent sacrifice is often made by investors in high-AUM funds. They pay for watered-down goods that will end up tracking the broader index while bearing the “small value” label in name only. That cost should be paid by the investment firm through reduced AUM, not by the investor.
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1. Source: Capital IQ. All listed stocks >$25mm in market capitalization. Figures 2-4 are based on 100 equal-weighted stocks at varying AUM with no more than 5x the daily trading volume allowed for any position. In figure 2, premium paid is the price increase in the remaining opportunities at each AUM threshold relative to the smallest $50mm AUM selection opportunities. In figure 3, percentage of value stocks left is the percentage of value stocks out of the total count of all market value stocks that are still investable. Figure 5 shows the average price/book valuation of each size decile of the US market each year.