Active managers sometimes tout their ability to select stocks in markets that are considered less informationally efficient and those that offer larger rewards to successful stock pickers. Smaller companies and those in emerging markets are typically presented as examples. What are the grounds for debate, and what do over 20 years of SPIVA^® Scorecards tell us about the historical record?

First, consider the efficiency argument. It is true that research coverage is broader and deeper in some markets than others, and it is intuitive to suppose that the likelihood of misvaluations is higher among more obscure companies. However, there is no reason to assume that the likelihood of undervaluation is higher than the likelihood of overvaluation; determining which is which may be no easier in well-researched markets than in less-researched ones.

Second, some markets do indeed offer larger rewards for successful active choices than other markets. One way to understand the magnitude of the opportunity set in a given market is through dispersion, which measures the degree of variation in the returns of an index’s components over a specific period of time and at a specific level of granularity. When stock returns are more similar, dispersion is lower and the value of stock selection skill is accordingly lower. Conversely, when dispersion is high, opportunities may be greater.

In Exhibit 1, we plot monthly dispersion for the S&P SmallCap 600^®, the S&P Emerging BMI and the S&P 500^®. Over the past 23 years, dispersion was consistently higher in the first two indices compared to the third.

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Drilling down, Exhibit 2 groups U.S.-based small-cap and emerging market active funds by the average dispersion registered in the category benchmark. We defined “low dispersion” as values falling below the 25th percentile, “high dispersion” as those above the 75th percentile and a third grouping encompassing all dispersion environments. In low dispersion environments, performance proved to be more challenging for large-cap and small-cap managers, with 67% and 73% of funds underperforming on average, respectively. However, even in high dispersion regimes, more than half of funds still underperformed in all three categories.

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Exhibit 3 shows that only two years—2012 and 2019—saw the majority of managers in the Emerging Markets Equity category outperform, both of which coincided with relatively low dispersion environments. In contrast, there were only three years of majority outperformance for large-cap managers and six years for small-cap managers.¹

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All told, the rare success of active funds confirms that while there may be greater potential for outperformance in some markets, greater opportunity for outperformance is no guarantee actual outperformance.

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Over the long term, the statistics become even clearer. As summarized in Exhibit 4, regardless of the level of dispersion and whether managers are seeking alpha in widely researched markets like large-cap equities or more specialized areas, outperforming the benchmark over longer horizons remained particularly challenging.

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