Many professional investors and academic researchers have long believed that little is better when it comes to stock size. Research has shown that the smallest stocks tend to beat their larger brethren on a long-term basis. Although the reason for higher small stock returns has not been definitively established, some researchers believe higher returns are compensation for the extra risk of investing in such companies.
Whatever the reason, another debate over small stocks has continued. On one side are those who believe the small stock market is less efficient than the market for big stocks, allowing active stock pickers to beat the market. On the other are the academic theorists who say that active investment management under-performs the markets for both small and big stocks.
A recent study by Standard & Poor’s has come down on the side of the passive investment advocates who say investing in small stock indexes is the best strategy. S&P says just one-third of active small stock mutual funds beat the S&P SmallCap 600 Index during the five years ended September 30, 2002.
S&P said the higher costs of active management might cause the under-performance. The costs of investing in small stocks are higher than the costs of investing in large stocks due to the higher transaction costs of trading illiquid securities. The average active small stock fund has an expense ratio of 1.58% of assets. Add to that a cost for transactions equal to 1.5% of assets to get the full cost of using active funds. Meanwhile, the Vanguard Small Cap Stock Index Fund, which tracks the S&P SmallCap 600 Index, had an expense ratio of just 0.27% of assets.
