By Scott Ronalds

Small funds produce better returns. This is the conclusion of a recent study, titled Pension Fund Performance and Costs: Small is Beautiful, which looked at the performance of U.S. pension funds from 1990-2006. Published by a trio of professors from Yale and two Dutch universities, the report found that the smaller funds generated the best risk-adjusted performance. Small in this context refers to both the amount of assets in the fund, and the type of securities held (i.e., small-cap).

The study included 711 pension funds, which invested exclusively in domestic equities (U.S. stocks). The size of the funds ranged from $1 million to $94 billion, with the median defined benefit fund holding $1.2 billion in assets (the median defined contribution fund was roughly half this size).

Among the findings were that U.S. pension funds on average tend to generate returns (after expenses and trading costs) that match or slightly exceed their benchmarks. Small cap mandates, on the other hand, outperformed their benchmarks by a sizeable margin – roughly 3% a year.

The researchers present an explanation as to why size plays a critical role in performance – liquidity. They observe that “liquidity limitations seem to allow only smaller funds, and especially small cap mandates, to outperform their benchmarks.” As a reminder, liquidity refers to the ease of converting an asset into cash swiftly and without a notable price discount. Illiquid investments are those that trade with much lower frequency and volume, and significantly higher bid/ask spreads, than their larger counterparts.

The professors point out that there is considerable literature which has established that illiquid investments generate higher returns. They opine that “since pension funds often have liabilities with a long duration, they naturally have longer-term investment horizons and may consequently invest in illiquid equity investments, thereby gaining the liquidity premium associated with these investments.”

It is easier for smaller funds to invest in illiquid securities because there are fewer shares of such companies outstanding and only a limited number of attractive investment opportunities. It can be very difficult for large, multi-billion dollar funds to accumulate meaningful positions in smaller companies without excessively bidding up share prices or exceeding maximum ownership limitations. In short, smaller funds are much more agile.

The paper points to other studies which show a negative association between fund size and performance, and suggests that the sheer size of the largest funds makes active management more difficult, and therefore outperformance less likely. Indeed, larger funds tend to look more like the index, as one of the authors points out.

While we don’t want to overplay the significance of one academic study, size is a crucial aspect of investing that often gets overlooked. Maybe now that ‘too big to fail’ has been thrown out the window, small may become the new beautiful.