Tailwinds Ahead for Active Management?


David Sowerby, CFA, Managing Director, Portfolio Manager

Some of the greatest rivalries in history were Athens vs. Sparta, Hamilton vs. Burr, Fischer vs. Spassky, Ali vs. Frazier, Ohio State vs. Michigan, etc. We can add active vs. passive stock investing to the list as well.

For a passionate stock investor, the active versus passive investment discussion can prompt a debate as spirited as any Ohio State vs. Michigan game. To be sure, this piece will not solve this ongoing debate. Rather, it recognizes that, depending on investment goals and objectives, it may not be an all or none decision, but perhaps some combination of active AND passive to meet portfolio goals.

Active managers of securities have a fundamental belief that skill wins out over longer market cycles. That skill can be expressed in many ways, but frequently comes down to the ability to allocate portfolio capital to companies that are more adept at capital allocation, which in turn will favor their shareholders over the long haul more than other companies. In addition, active managers look for valuation discrepancies, where a company’s current value trades at a discount to its longer-term intrinsic value. Lastly, when it comes to portfolio construction, active managers typically construct portfolios with fewer holdings than an index under the belief that if you are an active portfolio manager, be active. With that backdrop on active management, let’s look at various market conditions that impact active manager performance.

A History of Market Extremes

To be sure, there are macro events that create greater headwinds and tailwinds for the actively managed stock portfolio. One of the most important macro factors influencing the probability of active managers’ relative performance is stock market breadth, which is the participation rate of stocks contributing to an index’s return. Recently, participation rates have significantly improved, adding better tailwinds for active portfolios. Conversely, when the major indices’ performance becomes concentrated in fewer stocks, active portfolio management can face near term challenges.

This condition has been especially prevalent in the Standard & Poor’s 500 Index over the last 4-5 years. The concentration of the twenty largest stocks in the S&P 500 has reached some of its highest levels of the past twenty years. Specifically, as of August, it rivaled the concentration from early 2000, which was the peak of the dot-com era. Interestingly, following similar levels of stretched concentration in 2000, active stock managers witnessed an extended period of outperformance versus the S&P 500 Index as a benchmark, which we are beginning to witness again.

Combined Weight of 20 Largest S&P 500 Stocks

Combined Weight of 20 Largest S&P 500 Stocks
Source: Strategas

Active vs. Passive – Differences in Portfolio Construction

In terms of portfolio construction, investing $100 in an active stock portfolio consisting of 50 stocks would likely be fairly evenly spread across those 50 companies. In contrast, investing $100 in a passive portfolio, like a market cap weighted S&P 500 index fund, would have a very different outcome. Today, the twenty largest stocks in the S&P 500 account for nearly 40% of the total portfolio, so of that $100 investment, $40 would be allocated to just 20 stocks and the remaining $60 would be sprinkled across the other 480 companies.

This means that the passive investor can have a disproportionate share of their capital allocated to just a few companies, even in a large portfolio with 500 companies. These portfolio construction characteristics can prevail for extended periods, as index funds continue to “buy high,” stretching the valuation rubber band of the largest index constituents in the process. Inevitably, however, valuation matters and the rubber band contracts, prompting many of the largest and more expensively valued stocks in an index to lag in performance.

Annualized Returns Table 1998-1999 2000-2005 2019-2020
S&P 500 Index 24.8% -1.4% 20.6%
Large Cap Core Active Manager – Median 23.1% 2.3% 18.4%
Large Cap Core Active Manager – 25th Percentile 28.7% 7.9% 22.3%

Source: eVestment, Universe: eVestment US Large Cap Core Equity

Most notably, this occurred at the peak of the Internet investment craze in early 2000, the last time the major indices, such as the S&P 500, were so highly concentrated.

While the dot-com bubble is accurately cited as an extreme period for active portfolio management, it was not an isolated event. Similar events also occurred in periods including the Nifty 50 in the early 1970s and the biotech bubble of the late 1980s. Notably, there was an extended period where mean reversion in the macro environment created a better tailwind for active portfolio management.

In closing, active investors hold the belief that demonstrated skill is repeatable. Encouragingly for active investors, periods of extremes, in which the median manager underperforms, can be followed by a period of active outperformance as market conditions change. It is difficult to time these transitions, which is why it is perfectly reasonable to have both philosophies, active and passive, represented in a portfolio.

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