Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D
A long, long time ago (well not that long – 2018) during a market regime far, far away (pre-pandemic seems so distant now), we wrote about the return of active management, or investment strategies built on traditional fundamental analysis (a.k.a. professional stock-picking) or quantitative factor tilting. At the time, we postulated that, after years of perennial disappointment having lagged cap-weighted passive indices, actively managed strategies would finally see a renaissance of sorts. At the risk of ‘cursing’ active management, we are publishing an updated thought piece suggesting the return of active management.
Over the intervening period (pre-and post-pandemic recovery) since our last update, the wait continues as passive continues to dominate with respect to relative performance and fund flows, as 85% of US-focused mutual funds have underperformed the S&P 500 Index over the trailing 3-year period ending 6/30/2022 according to the June 2022 SPIVA Study. Indeed, it’s been a struggle for actively managed funds worldwide (Figure 1), not just in the U.S.
Figure 1 – SPIVA Study Illustrates the Challenge of Actively-Managed Funds versus Passive Peer Benchmarks Over the Trailing 1-, 3-, and 5-Year Periods (Ending 6/30/2022) (High % = Top Performance)
Source: S&P Dow Jones Indices SPIVA Study Ending 6/30/2022
Looking specifically at the US Large Blend category in Morningstar, we also see the S&P 500 Index (using Vanguard S&P 500 Index Fund as a proxy) sitting at the top of the fund category for the trailing periods ending 10/31/2022 (Figure 2). Note, we refine the category list to only include 1) traditional long-only active funds as designated by Morningstar, and the oldest share class.
Figure 2 – Similar Findings Comparing the Vanguard 500 Index Fund (Inv Class) versus Active Large Blend Category Based on Morningstar Classification (Performance Ending 10/31/2022) (Low Rank % = Top Performance)
Source: Morningstar Office
But notice that the % ranking for the passive indices are in decline even if they still outperform the majority of active funds. Could we be entering that much long-sought period of active outperforming passive?
With cap-weighted indices like the S&P 500 at top-heavy record levels relative to history (Figure 3), passive indices have enjoyed a major tailwind as a handful of large cap technology stocks dominate overall market return and variance (a.k.a. Top N effects where a small number of large stocks equal the systematic risk of the broader market). This has led cap-weighted indices to dominate alternative index constructions, such as equal-weighted indices and generally posing a headwind for active strategies that tend to weight individual holdings based on ‘conviction’ or equal-weighting of best ideas.
Figure 3 – The ‘Top-Heaviness’ of the US Equity Market Exceeded That of the Prior Peak During the Late 1990s Dot-Com Bubble
However, there might be a ray hope of emerging in 2022 for actively managed strategies. The equal-weighted S&P 500 is starting to outperform the cap-weighted S&P 500 for the first time in quite a while (Figure 4), as the top-heavy technology names that dominate the latter begin to lag the broader market. Generally, most actively managed funds will underweight or not own the biggest names in a cap-weighted index, mainly to differentiate their portfolio from that of a passive index or feared being labeled with low ‘Active Share.’
Figure 4 – Equal-Weighted S&P 500 Index Outperforming S&P 500 Index As We Move Past the Worst of the Pandemic
Source: Bloomberg (Monthly Through 10/31/2022)
In addition, the valuation gap between the S&P 600 Value Index (Small Cap Value) versus the S&P 500 Index has narrowed from the post-pandemic extreme levels when investors were extrapolating technology growth success well into the future versus the broader market.
Figure 5 – The Price/Book Valuation Gap Between the S&P 600 Small Cap Value Index versus the S&P 500 Index Has Narrowed from the Extreme Levels Reached During the Pandemic
Greater market breadth and a narrowing of valuation gaps may prove to be the necessary tailwinds for active management to finally make its comeback. Regardless of whether a comeback manifests itself, investors should be mindful of how systematic forces can influence (market breadth, small vs large, valuation gaps) the relative fortunes of active management. Even the most skilled stockpickers can be held hostage to these systematic forces that have proven to be major headwinds during the extreme periods of market concentration and tech growth dominance.
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate however 3D Capital Management, LLC (3D) does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete. This article does not constitute an offer to sell or a solicitation of an offer to purchase interests in any investment vehicles or securities. This article is not a prospectus, an advertisement, or an offering of any interests in either the Strategy or other portfolios. This article and the information contained herein is intended for informational purposes only. It does not constitute investment advice or a recommendation with respect to investment. Investing in any strategy should only occur after consulting with a financial advisor.
3D does not approve or otherwise endorse the information contained in links to third-party sources. 3D is not affiliated with the providers of third-party information and is not responsible for the accuracy of the information contained therein.
Past performance is no guarantee of future results. None of the services offered by 3D are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as of November 21, 2022 and are subject to change as influencing factors change.
More detail regarding 3D, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing firstname.lastname@example.org or visiting 3D’s website at 3d.freedomadvisors.com.