Topic Tags: Active Management

Where Should Investors Land on the Aggregate Continuum?

Contrary to widespread belief, fixed income aggregate strategies offer a continuum of active risk and return profiles. While aggregate strategies broadly aim to provide income, diversification, and liquidity, varying degrees of excess return exist. Investors must choose what suits their active risk and return goals.

Fixed income mandates are described by their beta and benchmarked to a similarly named index. For example, long credit is benchmarked to the Bloomberg Long Credit Index and high yield is benchmarked versus the Bank of America High Yield Master II Index. Once a beta is selected, then an alpha objective is chosen for the mandate. Some mandates in the universe have an alpha target of benchmark plus 50 basis points (bps), while others target an excess return of 100bps or more.

However, this is not true for aggregate strategies. The beta and index are the Bloomberg Aggregate Index. Rather than having different objectives, aggregate mandates have different “asset classes.” The aggregate continuum should not be thought of as different asset classes, but rather different active risk and return profiles.

This white paper outlines considerations for investors when choosing a fixed income aggregate strategy, including an overview of the Bloomberg Aggregate Index, how investment managers can generate active risk, excess return targets, and the important distinction between risk and active risk.

Small Caps: Unprofitables Lead, Active Managers Lag, But Can it Last?

At the start of 2025, very few could have predicted the wild ride that awaited equity markets. After a volatile period that culminated on April 8, U.S. equities achieved several new all-time highs, with small-cap equities reaching a first all-time high since November 2021. Absolute returns have been substantial, as the Russell 2000 rose nearly 42% off the market bottom through October 31. Despite renewed volatility in November as expectations for another Federal Reserve rate cut fluctuated, small-cap equities have led large-cap equities since April 8. As is expected in the first six months of a bull market, low quality, including residual volatility, short interest, non-earners, and beta, propelled the small-cap market. Conversely, active managers favor high quality companies, typically characterized by high returns on equity, strong balance sheets, and low leverage. As a result, this factor backdrop is a known headwind for many active managers across the small-cap universe, and this bull market is no different.

No Small Headwind for Small-Cap Managers

Small-cap equities are in a prolonged period of underperformance relative to large-cap stocks, but this trend has shown early signs of reversing in the aftermath of intra-year market lows on April 8, with the Russell 2000 Index up roughly 41% since that time. Interestingly, unprofitable companies within the benchmark have led the way, gaining more than 72% compared to a relatively meager 29% for profitable constituents of the Russell 2000 Index. Although the overall small-cap equity market is currently in line with its average bull market return amid this run, recent performance of unprofitables far exceeds historical norms. This dynamic can be observed in the chart above.

One of the major consequences of this trend is significant underperformance of actively managed small-cap strategies, which typically eschew companies with poor fundamentals. Specifically, the average active small-cap blend manager (as represented by the Morningstar category average) has underperformed the Russell 2000 Index by more than 10 percentage points since April 8, an extreme not seen in roughly 25 years. On the positive side, active small-cap strategies have slightly outperformed profitable small-cap companies, which are more likely to be included in these types of funds. Should this persist, it may be a tailwind for active managers, as profitable companies may have additional upside from here based on trends observed in prior bull markets. That said, more accommodative monetary policy and fiscal support may lead to additional strength from unprofitables and, as a result, further underperformance of active managers.

2025 Investment Symposium

Watch the flash talks from Marquette’s 2025 Investment Symposium livestream on September 26 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.

Why Are Emerging Markets Investors Removing Their China Exposure?

Emerging markets (EM) equities have gone through cycles of performance throughout time, creating varied investor sentiment towards the asset class. Recently, discussions around excluding China from investment portfolios have become more common, spurring the growth of active EM ex-China strategies. This newsletter explores the current landscape of EM investing, examines the drivers of the EM ex-China trend, and analyzes the performance impact of removing China from an EM allocation.

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.