Topic Tags: Active Management

The Changing Current

The impressive strength of U.S. equities in recent years has drawn significant investment from both domestic and international investors, but a closer look reveals a shift in how investors are attaining exposure to the asset class. The chart above illustrates the cumulative net asset flows for various U.S. equity investment vehicles since 2009 and indicates that a growing number of investors are embracing passive strategies. To that point, more than $2.5 trillion has flowed from active to passive management in the last 15 years, with most of the dollars having been directed toward ETFs.

There are many factors that have contributed to this trend. First, mobile brokerage platforms and improvements in technology have made investing more convenient and cheaper for retail investors, with thousands of low-cost products now available that track major stock indices like the S&P 500. Second, many institutional investors have reallocated portions of their U.S. equity portfolios to passive strategies to save on fees, while seeking higher returns via active management in other asset classes like private equity. Additionally, many active U.S. equity strategies have struggled to keep pace with the broad market. Specifically, just 15% of active U.S. large-cap managers have outperformed the S&P 500 over the last decade due a small handful of companies (i.e., the “Magnificent Seven”) having been responsible for an outsized portion of U.S. equity market returns in recent years. This trend also aligns with what is often referred to as the “paradox of skill,” which states that as the absolute level of skill in a space increases, the relative skill among the players in that space often decreases. While this framework has been applied to everything from the NBA to chess, it may also be partly responsible for the decrease in the return premiums earned via active management in the U.S. equity market. If true, this trend poses interesting questions related to whether similar alpha compression will occur in fast-growing spaces like private markets.

What Does Elevated Index Concentration Mean for Active U.S. Equity Managers?

Indexing has risen in popularity over the last decade, particularly for U.S. equity investors. The fees are lower and indexing is perceived as less risky, with investors primarily seeking beta exposure to the market. However, these indices have evolved against an ever-changing economic and financial market backdrop. As a result, several unintended structural issues have emerged, particularly related to concentration risk. Understanding this evolution and how it could alter the overall exposures within a broader portfolio is critical, as these indices are not static. Notably, the composition of some indices alongside the increase in passive capital has created headwinds for active managers and helps to explain recent performance challenges.

This newsletter examines the progression of passive management, how and why U.S. equity index concentration has increased in recent years, and the effects and risks investors need be aware of across the market capitalization spectrum.

The Dynamic Duo

In 2023, investors were stunned by the robust performance of seven prominent mega-cap stocks deemed the “Magnificent Seven.” Largely beneficiaries of the AI craze, these seven companies comprised almost 28% of the S&P 500 at the end of 2023. This narrow breadth and concentration within the market posed challenges for active large-cap managers who struggled to keep pace with benchmarks without matching the weight of this group in their portfolios. While market breadth has started to improve among large caps, a similar trend is now emerging in the small-cap universe with just two stocks, Super Micro Computers and MicroStrategy — now the two largest companies and weights in the Russell 2000, spearheading the majority of the index’s returns this year.

Since the onset of 2023, Super Micro and MicroStrategy have posted remarkable returns of 1,093% and 936%, respectively, driving up their weights in the Russell 2000 to 1.94% and 0.85%. For perspective, prior to this year, the index’s most substantial single weight since 1985 was 1.45%, at the peak of the dot-com bubble. Like the Magnificent Seven, these two firms have profited from the proliferation of AI. MicroStrategy has also capitalized on the recent cryptocurrency surge over the past six months.

While the performance of these stocks captivates attention, they have become a pain point for active small-cap managers trying to outperform the Russell 2000. Leaving aside fundamental underwriting, many small-cap managers are constrained by prudent limits on market capitalization for the companies they can invest in, and these two outsized outperformers fall far beyond those. As of March 18, Super Micro had a market cap of $55.5 billion and MicroStrategy stood at $25.3 billion, both in large-cap territory. While the Russell 2000 maintains a $6 billion market capitalization threshold for small-cap stocks, the index is only reconstituted once annually, and both companies fell within the limit in April 2023 when FTSE Russell last evaluated index characteristics. Despite their stellar performance, many managers will be unable to allocate to these companies due to their size. Though managers with prior allocations may be able to hold their positions, it could prompt scrutiny regarding the discipline of their investment approach. This predicament mimics the struggles seen in the large-cap space last year, where a select few companies drove much of the market’s performance and active manager relative weights dictated attribution. With the next Russell reconstitution not slated until June 28 of this year, active small-cap managers may have to get creative in order to navigate these challenges.

U.S. Equities: Surprising Strength Gives Way to Macro Risks

Equity market strength through the third quarter continues to challenge the common expectation going into the year. Cumulatively through September 30, the slowdown many investors anticipated has been averted thus far as the strength in certain segments of the market has more than offset the weakness in others. Following the strength of value equities — with Energy the lone positive sector in 2022 — markets experienced a shift in leadership to begin 2023. Companies that were challenged by supply chain issues and wage pressures rebounded to begin the year, primarily within growth-oriented sectors including Communication Services, Information Technology, and Consumer Discretionary. Overall, markets were strong through the first nine months of the year, as the S&P 500 rose 13.1%. However, September — historically the worst month of the year for equity markets — saw a somewhat unsurprising pullback. As we enter the final quarter of the year, we feel it is important to examine the underlying market dynamics driving performance and highlight the risks of a narrow market as well as the opportunities available on the sidelines.

Selling Insurance: An Option for Diversification

The Aflac Duck, the LiMu Emu, and the GEICO Gecko may be fictional insurance salespeople (or sales-animals, perhaps), however, the market participants involved in the selling of financial insurance are all too real. Put options are a popular form of such insurance, as these instruments afford the option holder the right to sell an underlying security at a given level, effectively insulating the holder against significant drops in the price of the underlying security. That said, much like bundling your home and auto with Jake from State Farm, this insurance comes at a cost based on implied volatility. For those who choose to purchase options contacts on the broad-based S&P 500 Index as a means of insuring portfolios against losses, this implied volatility is measured by the VIX Index, which uses at-the-money S&P 500 Index options to assess expectations of near-term market fluctuations. Over the long term, these expected volatility levels tend to be higher than what is actually exhibited. Specifically, since the start of 1990, implied volatility of the S&P 500 Index was greater than what was subsequently realized in roughly 87% of daily observations, and the difference between the two was roughly 4.5% on average over the same time period. This phenomenon leads to the systematic over-pricing of put option contacts and is highlighted in the top half of this week’s chart.

The data points noted above demonstrate the fact that selling insurance contracts on the U.S. equity market has generally been a profitable endeavor over the last several decades. To that point, the CBOE S&P 500 PutWrite Index, which is comprised of short positions in at-the-money put options on the S&P 500 Index and short-term Treasury bills which serve to collateralize the option positions, is an effective tool for measuring exactly how beneficial this activity can be for investors. On a trailing 10-year basis as of September 30, the PutWrite index notched an annualized return of 6.7%. While this is significantly lower than the 13.1% figure for the S&P 500 over the same period, the PutWrite benchmark has notably delivered that performance with a lower annualized standard deviation — 9.7% vs. 15.0% for the S&P 500. Performance of the PutWrite benchmark during down markets has been particularly compelling, with the index outperforming the S&P 500 in six of the last seven calendar years during which the S&P 500 was negative. This performance pattern can be observed in the bottom half of this week’s chart. It is important to note that active managers within the space can provide additional value over the PutWrite index by selling the most attractive options, diversifying the portfolio of options across different strike prices and tenors, and optimizing the pool of cash with which the options are collateralized.

Readers should be aware of the fact that options selling is not without risk. Performance typically lags during strong, upward-trending markets, and a relatively high equity beta means that these types of strategies will be more correlated to stock market movements than other diversifying alternatives. That said, options-based strategies could present attractive opportunities for many investors due to the systematic processes with which they are implemented, the lower fees and better liquidity terms associated with them relative to other alternatives, and the likelihood that the volatility risk premium will persist into the future. Marquette will continue to monitor the persistence of this premium, conduct due diligence on investment managers in the options space, and provide education and recommendations to clients accordingly.

2023 Investment Symposium

Watch the flash talks from Marquette’s 2023 Investment Symposium livestream on September 15 in the player below — use the upper-right list icon to access a specific presentation.

 

Please feel free to reach out to any of the presenters should you have any questions.

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Past performance is not indicative of future results. For full disclosure information, please refer to the end of each presentation. Marquette is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Marquette including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.

Emerging Opportunities Beyond China

Equity performance in China, with the MSCI China Index down 5.5% through the first half of the year, has disappointed amid hopes for a strong post-COVID recovery. While macro data started the year strong, momentum quickly waned, with a cautious consumer and a slowdown in manufacturing. China’s property sector troubles have continued, and U.S./China tensions remain, with the U.S. moving toward stricter regulation and reduced investment in the Chinese technology sector in 2024. Along with human rights concerns and the general unpredictability of the Chinese government, the debate around China’s investability continues on.

Take China out of the emerging markets picture, however, and the story is different. The MSCI Emerging Markets Index excluding China — the largest single country weight in the index at nearly 30%¹ — has outperformed the broader benchmark since late 2021. Latin American countries like Brazil and Mexico — almost 6% and 3% weights in the index, respectively — have benefited from central banks that began their monetary policy tightening cycle earlier. Additionally, as renewable energy trends continue, Latin American regions rich in natural resources should see exports grow. Nearshoring trends have also benefitted emerging market countries such as Taiwan — the second largest country weight in the index at nearly 16% — and Mexico, with the latter exporting nearly as much to the U.S. as China, something not seen since 2003. And in India — the third largest country weighting in the MSCI EM Index at approximately 15% — government reform programs have drawn in significant investor flows.

Looking into the second half of the year, the evolving macro picture in China, including any potential stimulus, will continue to be a driving factor of overall MSCI EM performance. And outside of China, there are a number of interesting trends playing out across the emerging markets space that should present investment opportunities for active managers.

 

¹All country weights as of June 30, 2023

GICS Reclassifies Away From Tech, Again

The Global Industry Classification Standards (GICS) were established in 1999 by MSCI and S&P Dow Jones Indices to categorize publicly-traded equities. Broadly accepted across the industry, the GICS classification system undergoes an annual review, which has resulted in only 12 updates to the classification system since inception. These updates can have significant impacts on the underlying performance drivers of sectors as well as the concentration of sector-specific indices. The Technology sector has been meaningfully impacted by the two most recent updates. In 2018, GICS broke the Technology sector up to create the Communication Services sector, which includes FAANG stocks Meta, Netflix, and Alphabet. While the update was less consequential this year, it again relocated some of the Tech sector’s largest constituents, increasing its concentration to new highs.

Effective after the close on March 17, 2023, 14 firms were reclassified, impacting five GICS sectors. Notably, Visa and Mastercard, previously two of the five largest Technology companies, along with PayPal, Fiserv, and others, were reclassified as Financials. As a result, the Financials sector is now more exposed to growth factors, including, on the margin, valuation risk from rising rates. The Technology sector, conversely, has become even more concentrated in two mega-cap stocks — Apple and Microsoft. The resultant weighting and concentration changes will impact active manager attribution metrics as well as the exposures achieved via sector-specific ETFs and are important for investors to be aware of. Lastly, while not implemented this year, another key proposal discussed concerned renewable energy companies. These stocks are generally categorized within the Energy and Utilities sectors, and future changes could represent another meaningful shift in GICS classifications.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Fixed Income Indexing: A Commitment to the Bottom

The equities market has experienced a tectonic shift from active to passive investing, with passive investors benefiting from index strength and meaningful fee savings. In fixed income, however, investing in indexing strategies tends to be a commitment to the bottom. The Bloomberg Aggregate Index — the standard index for broad fixed income investing — tends to underperform most active strategies. While there may be shorter time periods where active managers trail the index, over longer time periods the index generally falls within the bottom quartile of universe performance and often in the bottom decile.

Due to the size of and inefficiencies within the fixed income market, there should be many opportunities for managers to take active risks and generate excess returns. Two common active management strategies for aggregate mandates are core and core plus, differentiated by the level of active risk and return objectives. Core strategies should be expected to outperform the index by 50–100 bps and core plus by 100–150 bps over a full market cycle. The vast majority of active managers outperform the index. In the core plus universe, the index’s rolling 5-year return was in the bottom quartile 14 of the last 20 years and in the bottom decile in 10 of those years. In the core universe, where the level of active return is lower, the index on a rolling 5-year basis was in the bottom quartile in 11 of 20 years.

To be fair, there are times when indexing pays. Many fixed income managers are “active” by systematically overweighting corporate and structured credit while underweighting Treasuries and agency mortgages to create a yield advantage. Outyielding the benchmark works well until it doesn’t. During risk-off periods of spread widening, the index tends to be one of the better performers within the universe. The two best examples of this are 2002 and 2008, when markets experienced a precipitance of spread widening due to the dot com bubble bursting and the sub-prime mortgage crisis, respectively. Those periods erased years of prior active management outperformance, though having a yield advantage remained beneficial longer-term, with those active managers outperforming in subsequent years.

While active is often the preferred method of accessing the fixed income market, an aggregate indexed strategy may be helpful as a risk management tool and indexed options may help investors take more tactical positions within fixed income sub-asset classes. Overall, investors should make sure they understand the risks and benefits of investing in active versus passive within fixed income and work with their consultant to create a portfolio that best serves their needs.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

 

Emerging Markets: Why Your Active Manager May Be Underperforming

2022 has been a challenging year for investors as both bonds and equities have produced substantial losses. This unusual environment is the product of a kaleidoscope of macro headwinds that have unfolded throughout the year. Against this backdrop, active emerging markets equity managers have generally failed to protect to the downside, with the average manager underperforming the index year to date through September.

There are several potential reasons why active managers have struggled in 2022. The Russian invasion of Ukraine in February caught most market participants off guard and resulted in substantial losses. China’s underperformance relative to the broader index has also served as a headwind for many investors. China is the largest exposure in the MSCI EM Index at 31% and has been challenging for managers to navigate this year given the country’s Zero-COVID Policy, property sector struggles, and negative investor sentiment amid geopolitical tensions. And lastly, the factor environment has dramatically shifted this year, with both Growth and Quality underperforming the broad benchmark. This newsletter further explores the impact that the underperformance of Quality has had on active manager returns this year.

Read > Emerging Markets: Why Your Active Manager May Be Underperforming

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.