Has Regulation affected Large Cap Returns


New York – Today in the Wall Street Journal is the quarterly mutual fund review for 2006. As is usual, the value funds outperformed the growth funds for the past five years and the past year’s worth of data. Additionally, the small cap stocks outperformed the mid-cap stocks, which outperformed the large cap stocks. Heading into the New Year, we expect that the traditional small cap rally will continue for the next several months (January Effect).

See below tables:

Mutual Fund Returns over 5-years to Q4 2006

Small Cap Mid Cap Large Cap
Growth 5.9 5.9 2.2
Value 13.6 12.8 7.8
Core 11.4 9.6 4.9

Mutual Fund Returns over 1-years to Q4 2006

Small Cap Mid Cap Large Cap
Growth 10.3 8.5 5.6
Value 16.5 16.0 17.9
Core 14.9 12.3 13.5

When comparing the 5-year returns with the 1-year returns, it is clear that the value funds have outperformed growth funds over both time periods. This is not a surprise, since it has been born out in a number of market studies over multiple time periods.

Also, in general, the 1-year returns have done better than the 5-year returns. Again, this is not much of a surprise, given the market cycle of the past 5 years. However, what is somewhat surprising is that the 1-year returns for large cap value and Core are relatively very strong, compared to the 5-year return.

Of course, this is not necessarily the prevue to a trend in the market, but it does beg the question, is there any logic that would support this apparent trend? The definitive answer is maybe.

Over the past year, key topics in the market have included commission disclosure and transparency and the demise of sell side research. Trouble is, whenever the word demise and sell-side start to appear together in sentences, the sell-side adjusts its business practices. Faced with providing disclosure on separating commissions into the research and execution, the sell-side has begun to look for ways to maintain or increase its commission pool.

Over the past two days, major papers have been covering the “hedge fund hotel” case, brought by the Commonwealth of Massachusetts against UBS. Since we covered the case in yesterday’s blog, we will not cover it here. However, the intention of UBS and large sell side institutions is to protect or enhance their commission generation by foster start-up hedge funds in UBS premises. This, of course, is called prime brokerage services. Since the hedge funds are not faced with Reg NMS, have less fiduciary responsibilities to clients and trade much more vigorously than the long only managers, the sell-side has engineered ways to harness the hedge funds execution along with fattening the commission structure via prime brokerage services.

This means that the slice of commission going to the prime broker gets larger. For example, under CSAs in Europe, third party research gets about 50% of the commission, with the remainder being allocated to the brokers’ executions and research. For the largest brokers in Europe, the third party research pool is only about 25% of the total.

We all know that hedge funds like to trade in liquid markets, so the question is, does the rise in large cap return over the past year, have anything to do with increased concentration of investment in larger cap stock? At this point, this is only a hypothesis at this point, it may develop into a theory as information evolves over the year.


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