Fund flows, which measure the net movement of assets into and out of investment vehicles like mutual funds and exchange-traded funds (“ETFs”), can provide a window into investor behavior and are often an indication of investor sentiment. Strong inflows can indicate optimism within a particular asset class or investment style, while outflows may suggest pessimism on the part of investors. That said, a robust market is not always supported by investor inflows, as underlying fund flows and market index performance frequently deviate. This phenomenon was on display in 2020 and merits further evaluation.

The S&P 500 index posted a double-digit return in 2020 and closed the year at an all-time high, despite record-breaking outflows from U.S. equity funds. Nearly $241 billion flew out of domestic equity funds in 2020, a figure that is more than four times the previous calendar year record set in 2015. Perhaps unsurprisingly, these outflows centered predominately around actively managed products, a trend that has been persistent since 2014. Active funds saw net outflows in every month of 2020, while passive funds enjoyed bursts of investor interest, with extreme net inflows in both March (after the market bottomed) and November (due to positive coronavirus vaccine news). Investor preference for ETFs over mutual funds is particularly noteworthy. ETFs have risen in popularity as a lower-cost alternative to mutual fund investing and carry little-to-no investment minimum with real-time pricing. In November, passive ETFs saw a staggering net inflow of more than $54 billion, which is $12 billion more than the last monthly record set in December of 2016. This historic net inflow provided a tailwind to an already optimistic investor base and propelled indices like the Russell 2000 index, which tracks the U.S. small-cap market, to post its strongest returning month on record.

Hefty inflows for passive vehicles, like those in November, can have unfortunate implications for active investment managers. Many of these investment professionals are constructing a relatively small basket of securities with the intent to outperform a benchmark, often with less risk, over the long term. Commonly, these managers focus on quality metrics like top line growth, gross margins, earnings, and lower debt levels to drive outperformance. When a wave of inflows hits passive products, we see a “rising tide lifts all boats” phenomenon that is largely detached from underlying stock fundamentals. This can cause a short-term price dislocation and distortion of investor sentiment. Ultimately, the immediate impact of fund flows is temporary, but the continued trend away from active management may pose a greater threat to the asset management industry if portfolio managers fail to improve benchmark-relative performance.

Print PDF > Record Flows: Another Headwind for Active Management

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.

Summer has arrived and with it comes the annual “Russell Rebalance,” or as FTSE Russell — the index administrator — officially calls it, the Russell Reconstitution. The last Friday in June brings a unique set of challenges for investors managing to one of Russell’s many indices. More than half of U.S. equity investment managers benchmark to a FTSE Russell Index and the Russell rebalance affects an estimated $9 trillion across these products.¹ The entire family of Russell U.S. indices is recast to reflect changes in the U.S. equity markets over the preceding year. Essentially, the rebalance resets market cap weightings and style designations, which ultimately drive shifts in the underlying sector distributions. This creates one of the highest trade-volume days of the year.

The market’s appreciation over the longest bull market in history pushed the market cap breakpoint between the asset classes to a peak in 2018 of $3.7 billion. As a result, the market cap threshold for constituents to be placed into either the large- and mid-cap focused Russell 1000 Index or the small-cap focused Russell 2000 Index has grown 150% since the Great Financial Crisis.

This past Friday, June 26th, marked the official reconstitution day. Notable movements in this year’s rebalance revolved around a few key sectors: Financials, Health Care, Industrials, and Information Technology. The Russell 1000 saw little movement in sector allocation, while the respective style indices, the Russell 1000 Growth and Value benchmarks, experienced the brunt of change. Technology now comprises a record 43% of the Russell 1000 Growth Index, a 2.3% rise, while the Industrials allocation fell to 4.6%, from 7.3%. The Russell 1000 Value Index was the recipient of those Industrials companies, rising from 9.6% to 12.4%.

From a market cap perspective, many banks within the Russell 1000 Financials sector moved to the small-cap index as investors sold economically sensitive stocks in the first quarter of the year. The Russell 2000 Index saw a 1.6% increase to the sector, bringing the total weight in Financials to 16.2%. As expected, many of these banks qualified for the Russell 2000 Value Index, which now has a nearly 29% weight to the sector. Likely the largest hurdle for active managers navigating the rebalance is the increased allocation to Biotechnology, an industry within the Health Care sector. These securities, many of which do not make money and have no established products, go against the investment philosophies of many fundamentally driven active managers. The Russell 2000 Growth Index now has a more than an 18% allocation to the industry. As managers settle into their new benchmarks, it will be pertinent to discuss these sectoral and capitalization changes in the context of future performance expectations.

Print PDF > Russell Rebalance: What Happened?

¹ FTSE Russell

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.

The rise of passive investing has been a multi-year trend among investors and currently accounts for nearly half of all assets within U.S. mutual funds and ETFs. The popularity of passive investing is not surprising given that the majority of actively managed funds charge higher fees and struggle to consistently beat their target benchmarks. However, the small-cap segment of the market bears watching, particularly among those investors that are passively invested.

This week’s Chart of the Week shows the percentage of companies over time within the Russell 2000 index that have no earnings. As of September 30, 2019, the percentage of companies within the Russell 2000 index with no earnings stands at 38%. This is one of the highest readings observed in nearly 25 years and is at levels typically not seen outside of recessionary periods.

Consistently strong passive inflows, a low interest rate environment, and general investor preference towards longer duration assets perceived to have recession-resistant, long-term secular growth drivers have helped to support companies with little to no earnings. This trend may eventually reverse and could bode well for active strategies that are structurally underweight this segment of small-cap. Regardless, it is important to acknowledge the growing trend and potential risk within the small-cap space.

Print PDF > The Hidden Risk Within Passive Small-Cap

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.