Passive management, or indexing, has been gaining greater acceptance among investors and advisors as an investment approach. This acceptance has come in no small part because numerous academics and financial publications have been quick to point out that investment managers do not consistently beat the market, i.e., regularly outperform a relevant index such as the S&P 500 or Russell 2000 or an index-based passive strategy.

Historical data supports this view—but only to a point. While many investment managers regularly fail to outpace their chosen benchmark (or a related index), there are a number of managers who have consistently outperformed the market over long-term periods. In our opinion, it is not necessary for all managers to beat the market in order for active management to be validated as an approach.

The other significant question is one of timing—namely, determining the appropriate span with which to measure the effectiveness of an actively managed approach. While it would be nice to outperform an index every year, it is as unrealistic to expect that as it would be to expect that an index would outperform active management every year. It is also unrealistic to expect a high degree of outperformance in the long term without experiencing some short-term underperformance periods. This is precisely our experience: While our Funds enjoyed consistent outperformance over five- and 10-year periods relative to the index, our outperformance was less consistent over shorter-term periods. This is not a criticism of the Funds, or of active management. Indeed, to limit one's evaluation period to a short-term time frame would be similar to saying that a batter must get a hit every time he steps to the plate in order to be considered exceptional.

While full market cycles are ideal for measuring both performance and manager ability because they include both an up and a down phase, they can vary considerably in length and can only be validated after a cycle's completion. One- and three-year time horizons rarely if ever offer both peak-to-trough and trough-to-peak periods. In contrast, five-year periods often include an up and a down phase, and thus the opportunity to fully evaluate a manager's skills. Therefore, in our opinion, rolling five-year periods offer a more meaningful period for measurement and to the extent that rolling 10-year (or longer) returns are also available, so much the better.

...It Don’t Come Easy

In evaluating the long-term case for active management, it’s worth asking why certain managers outperform passive approaches over meaningful performance periods. We believe the reasons were identified by investment counselor and author John Train in his book, The Money Masters. Train concluded (and we agree) that the most successful investment managers generally possess three qualities: discipline, consistency of application and independent thought.

If one were to interview the most successful investment managers, one would find that each had a discipline that was easily explainable; that each consistently applied this discipline over a long enough period for it to be viable; and that each was practicing his or her own work, not copying that of another.

We believe that a willingness to stick to one's approach, regardless of market movements and trends, is also critical to long-term outperformance. This is especially important during market extremes because many active managers will exhibit style drift or other changes in their discipline most frequently when their investment style falls out of favor or is stressed. The tech bubble is an important example of a time when the value style of investment management was often abandoned, i.e., the tenets of value investing were ignored at the expense of growth investing. However, those managers who stuck with a value-based discipline ultimately distinguished themselves during the entire cycle. Those who capitulate to the consensus are often the greatest losers.

Disciplined Focus

We suspect that most managers who have outperformed the market would likely describe their goal as generating high absolute returns rather than beating an index or the market. Beating the market is never the focus, only a happy byproduct of the successful execution of investment discipline.

Inherent in this, certainly for us, is close attention to risk management. While most managers focus on the return side of the equation, we believe that the most successful also devote equal attention to risk. Managing risk is crucial because failing to do so can erode, or even destroy, returns. Successful active management also entails a willingness to think independently in terms of sector and industry weight ings. It is not unusual for the most successful managers to be significantly out of sync relative to a benchmark index with respect to industry and sector weightings (commonly referred to as tracking error). As Sir John Templeton famously said, "It is impossible to produce superior performance unless you do something different from the majority."

Active management also offers potential benefits beyond performance. Unlike a passive approach, active managers are not required to invest cash inflows at the time of receipt when market conditions or prices may not be conducive. They may screen for quality and use buy/sell triggers as a means of reducing risk. While a passive manager must own everything, an active manager has the freedom to look for attractive stocks across the targeted universe.

This is especially important in the small-cap universe, which includes more illiquid, under-followed companies with greater price discrepancies. In addition, during periods of market dislocation, such as what we witnessed in 2008, active managers have the ability to capture valuation opportunities beyond their respective indices—an opportunity set that would be lost if one were limited to owning only the constituents that make up the index. For example, the Russell 2000, while quite broad, only includes 2,000 of the 5,000 companies that make up the small-cap universe (those with market caps up to $2.5 billion). We believe that the small-cap asset class is ideally suited for active management given its enormous size, lack of institutional focus and limited research availability.

So How Have We Fared?

As experienced, active small-cap managers, we have more than a rooting interest in the issue of active versus passive management. In addition, we have always shared a common goal with our investors: consistently above-average long term results on both an absolute and risk-adjusted basis. In fact, more important than any argument that we could make in support of active small-cap management are the returns in the tables below, which make a powerful case for active small-cap management and an even stronger one for our own disciplined approach. It is also important to note that each of the Funds enjoyed similar long-term outperformance on a risk-adjusted basis versus the Russell 2000—as measured by five-year rolling Sharpe Ratio. At Royce, we take great pride in our Funds' long-term performance records.