For many passive investors, the belief in efficient markets is core. But how efficient are markets at different parts of the capitalization spectrum?

A new paper by CEM Benchmarking Inc. looks at the historical performance of actively managed portfolios for dedicated U.S. large cap equity portfolios and dedicated U.S. small cap equity portfolios for large U.S. defined benefit pension funds.

It found that, over the period from 1996 to 2017, almost half of large cap U.S. equity portfolios outperformed their benchmark gross of costs, which indicates market efficiency. However, when looking at net of costs, this wasn’t the case.

“The sample size of 1, 241 portfolios is large enough to conclude at a 99.8 per cent confidence level that, net of costs, large cap. U.S. equity portfolios held by large pension funds had a less than a 50 per cent chance of outperforming the market,” the research said.

For large cap U.S. equity portfolios, this suggests indexing is the most sensible option, it noted. “When we look there we find the exact same things that the academics do ⁠— that this is a broadly efficient market and it’s just not something that you can put money into, research, pick better stocks and do better than someone who is indexing,” says Alex Beath, a senior research analyst at CEM Benchmarking.

On the other hand, the research found small cap U.S. equity portfolios outperformed the market both gross and net of costs, showing clear evidence of market inefficiency. “The sample size of 2,172 funds is large enough to conclude at a precision of five nines that small cap U.S. equity portfolios held by large pension funds had a better than 50 per cent chance of outperforming the market before costs and that markets were inefficient and beatable,” the research said.

Overall, a lot of pension funds are trying to chase alpha and beat the market, notes Beath, and how they allocate these dollars is usually guided by recency bias. “I think the biggest take-home for big investors is, if they want to know if they should be investing or if they should be putting money into chasing alpha, then they should be doing it in asset classes where there’s some evidence that that’s actually going to work long term.

“And so I think this kind of paper shows a simple and really nice example that most funds should be passive in large cap stocks and active in small cap stocks. And if they did that, they’d save a lot of money as opposed to being active in both.”