The Undiscovered Connection: Value-Led Periods and Active Management—Royce
article 10-29-2020

The Undiscovered Connection: Value-Led Periods and Active Management

In our research into small-cap performance patterns, we uncovered a connection that we believe is significant. There seems to be a notable historical trend of active small-cap managers outperforming the Russell 2000 Index in periods when value stocks lead, while trailing the small-cap index when growth stocks lead.


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What's Happening to Active Small-Cap Management?

Contrary to some investors’ perception, active small-cap managers actually have a strong relative performance record. Comparing Morningstar's Small Blend category average (our proxy for active small-cap management) to the Russell 2000 Index over monthly rolling five-year periods reveals that the Small Blend average beat the index 60% of the time. What accounts, then, for the recent poor relative results of the active small cap managers? We recently completed research into small-cap performance patterns that revealed a connection that we believe is significant. There seems to be a notable historical trend of active small-cap managers outperforming the Russell 2000 Index in periods when value stocks lead, while trailing the small-cap index when growth stocks lead. If this pattern holds, it carries a number of important implications for the current market, particularly if we are beginning an extended period of outperformance for value.

Small Blend Funds Often Succeed When Value Leads

Our research first compared monthly rolling five-year returns for the "as published" Morningstar Small Blend category average to the Russell 2000, dating back to the index's inception in 1979. We then separated each rolling five-year period into those in which the Russell 2000 Value Index led the small-cap market, and those in which the Russell 2000 Growth Index led.

The results were striking. Though the Morningstar Small Blend category average beat the Russell 2000 in 59% of all monthly rolling five-year periods, it actually outperformed in 81% of value-led periods, but in only 15% of growth-led periods. And most periods—66%—were value-led, which contributed to greater relative success for active management.

Small Blend Active Management Has Outperformed More in Value-Led Markets
Percentage Morningstar Small Blend Category Average Beat the Russell 2000 from 12/31/78 through 9/30/201
66% were value-led periods | 34% were growth-led periods

active management outperformed in value-led markets

Source: Morningstar
1There were 501 U.S. Fund Small Blend Funds tracked by Morningstar with at least five years of performance history as of 9/30/20.
2 5-Year Monthly Rolling Returns from 12/31/78 through 9/30/20 (442 periods)
The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Scrutinizing Our Findings

These results were so compelling that we challenged them with four questions:

1. Is the Small Blend category an appropriate proxy for active small-cap management?
There are a number of limitations to using the Small Blend average. First, until recently1 it only covered mutual funds, a subset of all active managers; second, Small Value and Small Growth managers are also active managers; and third, while Small Blend funds may be intentional about their style positioning, it may also be a residual of where their managers see current opportunities. We chose to use Small Blend as an active management proxy primarily because it is relatively style neutral and therefore a more appropriate comparison to the Russell 2000. Moreover, we feel confident that most observers would expect Small Value managers to fare better versus the Russell 2000 in value-led periods. This beneficial relationship for Small Blend managers, however, was more unexpected.

2. How could this data show such strong results when so few active small-cap funds are currently outperforming the index?
The idea that very few funds are outperforming the index is somewhat exaggerated since 24% of Small Blend funds (main class only, 37 out of 152 funds) beat the Russell 2000 Index on a trailing 10-year basis ended 9/30/20.

3. Has this advantage been due to survivorship bias or funds moving from 'Value' to 'Blend'?
No. According to Morningstar, the Small Blend category average is in effect a frozen snapshot. We calculated trailing five-year returns from historical monthly category average return data that reflects all funds in existence that were classified as Small Blend in that month.

4. Has this relative performance connection been consistent over time?
The active spread of Small Blend versus the Russell 2000 for the trailing five years seems to have roughly tracked periods of value and growth leadership through history. This chart shows the active spread in green tracked along the spread between the Russell 2000 Value and the Russell 2000 in gray. Periods of leadership for growth are shaded—they were relatively rare until the most recent ten-plus-year period (2008-9/30/20).

1As of month-end November 2016, Morningstar combined ETF's with open-end mutual funds in the Small Blend Category.

Active Spread of Small Blend vs. the Russell 2000
Monthly Rolling Average Annual 5-Year Spread Ending 9/30/20

active small-cap vs Russell 2000 5yr Spread


What explains this connection?

We wanted to know why value-led periods are far more conducive to active outperformance than growth-led periods. Our view is that two distinct factors affect this outcome: equal-weighted portfolios vs. cap-weighted indexes and active managers' training.

Equal Weighted Portfolios vs. Cap Weighted Indexes

First, most actively managed portfolios weight their holdings closer to equal weighted than capitalization weighted. This means that active managers are likely to be challenged when trying to keep pace with their respective indexes in periods with narrow leadership—those dominated by a comparatively smaller number of stocks at the upper range of the index constituents.

Growth-led markets tend to demonstrate narrow leadership more often than value-led markets, which typically feature broader participation. 2019’s results offer an instructive example of this performance profile. The market-weighted Russell 2000 went up by 25.5% in 2019, and increased by 23.5% on an equal-weighted basis. During the same year, the Morningstar Small Blend category tied with the equal-weighted Russell 2000, returing 23.5%.

Extending back in time, the relationships among value and growth, equal-weighted and market cap-weighted, and active and passive become even clearer. For the five years ended 12/31/19, small-cap growth led value (+9.3% vs. +7.0%), the Russell 2000 led the equal-weighted index (+8.2% vs.+ 6.7%), and the unmanaged (that is, passive) small-cap index led active managers (+8.2% vs.+ 6.7%). Unsurprisingly, over this same period only 32% of Small Blend funds (main class only, 64 out of 203) beat the Russell 2000.

From these observations, we would venture that value-led markets are characterized by a larger number of stocks advancing—and that this positive breadth helps create an advantage for active management.

In Sync: Growth, Cap-Weighted, and Passive Led
Five Years Ending 12/31/19 (%)

growth cap-weighted passive led 2000-2015

Active Managers' Training

The classic training for portfolio managers and analysts contains a heavy dose of valuation work. Successful active management can be distilled to identifying situations where the intrinsic value of a company is appreciably higher than its current stock price, and this may be a second factor in Small Blend’s advantage in value-led markets. The ability to effectively use various valuation metrics is integral to this practice. As a result, active Small Blend managers will lean towards stocks with valuations selling for less than their intrinsic value and quite often less than their relevant benchmark.

Seen this way, most active Small Blend managers could be described, to some extent, as value managers. Their respective investment disciplines will make them hesitant to own, and certainly reluctant to hold at the top end of their portfolios, stocks whose valuations are meaningfully higher than their index. Yet these are precisely the companies that lead in growth-led markets. These high-valuation stocks are heavily weighted in the indexes, but either not held, or underweighted, by the majority of active managers.


What are the implications for investors?

With the usual caveats about past performance being no guarantee of future performance, there has been a historical trend of active small-cap managers outperforming the Russell 2000 when value had market leadership. So the correlation of growth style outperformance and passive outperformance is particularly relevant to investors if the period of growth’s leadership is ending, even more so after a multi-year period when small-cap passive assets have significantly increased. We believe such a change in leadership may be starting (See ‘Making the Case for Small Value Leadership’ section).

Certain market environments have seen more frequent value outperformance than others. The overall market level of return for small-caps is one factor that has coincided with the frequency of value’s outperformance. When the five-year return on the small-cap index is 5% annualized or lower value has outperformed in only 47% of the periods. However, when 5-year annualized returns have been in the 5-10% range, value has outperformed 69% of the time. We think that’s particularly relevant now because Royce’s expectation for small-cap returns over the next five years is in this 5-10% range.

Russell 2000 5-Year Annualized Return Ranges
Monthly Rolling from 12/31/78 through 9/30/20

Range  Periods R2K Value Beat R2K Growth    Value Avg Growth Avg Avg Spread
≤ 5%
47% 2.1% 0.5% 1.6%
69% 10.2% 5.0% 5.2%

If subsequent annualized returns fall within this range, we believe that the odds favor small-cap value outperforming small-cap growth over the next five years. Consequently, we also think it is likley that this could be a period of outfperformance for active management.

What are the implications for Royce Funds investors?

This dichotomy of relative performance vis-à-vis the Russell 2000 during value-led periods and growth-led periods has had meaningful impacts on most of our portfolios’ performance. To illustrate using our five largest Funds—Royce Opportunity, Pennsylvania Mutual, Premier, Special Equity, and Total Return—we have historically seen a notable difference in outperformance frequency in value-led periods versus growth-led periods. We believe that the same factors affecting other active managers have affected our Funds as well. 

Royce Funds Outperformed in Value-Led Periods
% Monthly Rolling 5-Year Periods Outperformed from each Fund's Inception through 9/30/20

Periods (%)
Periods (%)
Periods (%)
Opportunity 85 50 65
Pennsylvania Mutual1 72 40 61
Premier 81 46 63
Special Equity 71 39 51
Total Return 87 34 58

1The data for Pennsylvania Mutual is from the inception of the Russell 2000 on 12/31/1978.
ROF led in 82/96, PMF led in 209/291, RPR led in 114/140, RSE led in 55/78, and RTR led in 101/116 of value-led periods.
ROF led in 66/131, PMF led in 60/151, RPR led in 67/146, RSE led in 51/131, and RTR led in 50/146 of growth-led periods. In all periods, ROF led in 148/227, PMF led in 269/442, RPR led in 181/286, RSE led in 106/209, and RTR led in 151/262.

Making the Case for Small Value Leadership

Our view is that small-cap value stocks will lead small-cap growth stocks over the next several years based on how far recent relative performance and relative valuation has been from historical precedent. We believe that regression to the mean has historically been one of the more powerful and reliable forces with investing. Simply put, when the current behavior of an asset class is an outlier compared with its longer term history, we think that the odds favor a reversal.

The seminal academic research on small-cap value outperformance, Fama-French’s 1992 Journal of Finance paper, noted that small-cap value stocks had outperformed small-cap growth stocks over the 27-year period from 1962-1989. Relative index performance supports this finding. Comparing the Russell 2000 Value and Growth Indexes shows that, on a monthly rolling 10-year basis since the indexes' inception in 1978, Value beat Growth by an average of 3.54%, and a frequency of 74%. Therefore, it is striking that the most recent experience has been so much of an outlier. As of September 30, 2020, small-cap value lagged small growth by 2.44%. Moreover, June was the 99th month in a row in which small-cap value trailed small-cap growth on a trailing 10-year basis. As the chart below shows, the magnitude and duration of small-cap value's underperformance is below a two standard deviation event that has never matched over the last 25 years—even during the late 1990's tech bubble.

Russell 2000 Value vs Growth Annualized Trailing 10-Year Relative Return as of 9/30/20

small-cap value 10 year underperformance

1The 10-year average annual total return through 9/30/20 was -7.09% for the Russell 2000 Value and 12.34% for the Russell 2000 Growth. -2.44% represents the difference. Standard deviation is a measure that quantifies the amount of variation or dispersion in a data set. Roughly 68% of the data values are within one standard deviation of the mean.

As one might expect, this relative underperformance of small-cap value stocks has contributed to an emerging valuation gap as well. When analyzing valuation, we prefer to use the ratio of EV to EBIT (enterprise value to earnings before interest and taxes) as we view this as a better valuation metric than price-to-earnings ratios for understanding a company’s true worth. Based on this EV/ EBIT measure, the common stocks that make up the small-cap value index currently sell at a 79% discount to those that make up the small-cap growth index, compared with a long-term average discount of 15%. By this measure small-cap value stocks sell at attractive relative valuation in our view.

Russell 2000 Value and Growth Shifted Median Relative LTM EV/EBIT1
Russell 2000 Value/Growth from 12/31/01 to 9/30/20

Russell 2000 value ev/ebit shows discounted valuation

1Last twelve months enterprise value/earnings before Interest and taxes.
Source: Factset

We hasten to add that as active managers we find some areas of small-cap value more attractive than others. Broadly, we see many cyclically sensitive stocks as undervalued and are concerned about the valuations of many interest-rate sensitive stocks, such as REITs and utilities. That said, the history of relative performance and relative valuation both signal to us the potential for a multi-year period of small-cap value outperformance.

Important Disclosure Information

Performance and Expenses
As of 9/30/20

  Average Annual Total Returns (%) Annual
Expenses (%)
  3Q20* YTD* 1YR 5YR 10YR 15YR 20YR 45YR/Since
Date Gross Net
Opportunity 11.11 -8.95 0.10 8.48 8.79 6.91 8.60 10.86 11/19/96 1.22 1.22
Pennsylvania Mutual 3.80 -10.28 -2.43 8.93 8.52 6.72 8.79 13.24 N/A 0.94 0.94
Premier 2.60 -11.02 -3.43 10.50 9.03 8.13 9.66 10.99 12/31/91 1.19 1.19
Special Equity 2.53 -7.73 -0.69 5.83 7.27 6.85 9.52 7.93 5/1/98 1.21 1.21
Total Return 0.26 -17.11 -11.46 5.47 7.25 5.76 7.71 9.41 12/15/93 1.23 1.23
Russell 2000 4.93 -8.69 0.39 8.00 9.85 7.03 6.88 N/A N/A N/A N/A
Russell 2000 Value 2.56 -21.54 -14.88 4.11 7.09 4.93 7.40 N/A N/A N/A N/A

*Not Annualized
1For Royce Pennsylvania Mutual Fund, the average annual total return shown is for the 45-year period ended as of the date shown above rather than since the Fund's inception.

Important Performance and Expense Information

All performance information in this piece reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Investment and Service Class shares redeemed within 30 days of purchase may be subject to a 1% redemption fee payable to the Fund. Redemption fees are not reflected in the performance shown above; if such fees were reflected, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at All performance and expense information reflect results of the Fund’s Investment Class shares. Operating expenses reflect total annual operating expenses as of the Fund’s prospectus dated 5/31/19 and include management fees, other expenses, and acquired fund fees and expenses for Royce Total Return Fund; and include management fees and other expenses for Royce Opportunity, Pennsylvania Mutual, Premier, and Special Equity Funds. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by any applicable Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies.

Mr. Lipper's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that past performance trends as outlined in this article will continue in the future.

For the Morningstar Small Blend Category: © 2020 Morningstar. All Rights Reserved. The information regarding the category in this piece is: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. Distributor: Royce Fund Services, Inc.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The performance data and trends outlined in this presentation are presented for illustrative purposed only. Historical market trends are not necessarily indicative of future market movements. The Royce Funds invest primarily in securities of micro-cap, small-cap, and/or mid-cap companies, which may involve considerably more risk than investments in securities of larger-cap companies (see “Primary Risks for Fund Investors” in the respective prospectus). The Funds may also invest to varying degrees in foreign securities which may involve political, economic, currency, and other risks not encountered in U.S. investments.



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