The bottom line:
Most active US managers beat their benchmark in 2022. Really? But what about other markets? And what about the near- and longer-term outlook?
As years go, 2022 was tough for investors.
Bonds – down. Property – down. Equities – down.
As well as being a tough year for equities, it was also an unusual one, in one respect at least.
In the market generally seen as the hardest to beat, the majority of active large cap US equity managers outperformed1 the US S&P 500 index. It was the first year this had happened since 2009 (you remember, Barack Obama was sworn in as president that year – for the first time – with Joe Biden as his vice president).
So, I hear you say, if managers outperformed the most challenging of equity markets, then surely, they delivered benchmark plus returns elsewhere. Well, not exactly.
Why did US managers outperform?
Put simply, it was the FAANGs (Facebook, Apple, Amazon, Netflix and Google) wot done it. While the acronym has remained the same, in practice the names behind it have varied but the common thread is tech, BIG tech. In the years leading up to 2022, this handful of stocks came to dominate the S&P 500 index and therefore its returns. For managers underweight these giants – ie most managers – after all, who would want to admit to actively deciding to hold c7% (Apple) or more of their client’s portfolio in just one stock – the result was years of underperformance. At the start of 2022, after riding the wave of tech-oriented lockdown induced activity, and as the pie chart on the left below shows, tech represented around 27% of the S&P index, with the top five tech stocks alone accounting for fully 19% of that exposure.
S&P 500 Sector Allocations 31 December 2021
S&P 500 Sector Allocations 31 December 2022
But as 2022 progressed, the Federal Reserve (and other central banks) could no longer tell investors and consumers with a straight face that inflation was purely transitory; it was proving rather too persistent for that. To rein it in, the Fed started to raise interest rates. And then some. At the start of 2022 US rates were in a range of 0% to 0.25%. By the end of 2022, after seven increases, they were in a range of 4.25% to 4.50%.
The combination of lower demand for their services from a reopening economy and the outsized discounting impact on distant future earnings of much higher interest rates hit tech valuations hard. While the broad index was down 18%, the combined value of Alphabet, Amazon, Apple, Microsoft and Tesla fell around 38%.
So, being underweight tech in 2022 was enough for many US active managers to deliver outperformance.
What about other markets? Well, not so good.
In the UK, there’s really no tech sector to underweight. Managers struggled as a narrow group of large cap energy (BP and Shell), financial (HSBC) and resource (Rio Tinto) stocks drove overall returns. Over the year, against a benchmark return of 0.3%, the average (median) manager delivered around -9.0%2. Perhaps over eagerness on the part of managers – and consultants! – to “green” portfolios is at least partly to blame.
Elsewhere, things were better but not good with both the average global equity and global small cap manager underperforming their benchmarks, by 1.4% and 3.4% respectively over 2022. Interestingly though, according to research conducted by S&P, in 2022, around 60% of “core” US small cap managers outperformed their index.
It is often the case that a good year for smaller capitalisation stocks coincides with a good year for active management as per the US experience. The logic is that when a market demonstrates “breadth” – ie more stocks by number outperform the benchmark – it benefits active managers, most of whom have somewhat of a smaller cap bias. If you think of an active manager as “fishing” for outperforming stocks, in a good year for small caps there will be a lot more fish to catch. In the years dominated by FAANG outperformance, there were very few and there’s a natural hesitancy about hooking any of the circling whoppers, lest they (ultimately) drag you under.
Can US managers continue to deliver? Can other managers start to deliver?
Well, there are reasons for hope, in the shorter term at least.
First, although tech had a shocker in 2022, that had a limited impact on its significant index allocation which, as the pie chart in the right above highlights, still stood at 23% of the S&P 500 (and 19% of the FTSE World Global index) at the start of 2023. If market performance continues to broaden out, the potential benefits to skilled active US and global managers are clear.
Second, there’s no doubt that several years of negative/low interest rates have played havoc with asset valuations, reducing the need for investors to discriminate between “good” and “bad” investments. As rates normalise and perhaps head higher, active managers will be confident that their analytic and valuation skills will once more be rewarded in what is likely to be a volatile, uncertain but more rational investing environment.
And then there’s “Peak Passive”. A bit of a unicorn this one; often talked about but never quite seen although some managers may claim to have glimpsed it. The idea is simple. For years, there’s been a seemingly inexorable transfer of money from active to passive investment. At some point, the argument goes, one or two things might happen.
Either so much money is transferred from one to the other that markets become highly inefficient and active managers make out big time exploiting mispriced opportunities. Or the trend goes into reverse and the wholesale indiscriminate sale of stocks from index funds creates the same opportunity set. But I wouldn’t hold your breath.
What action should you take, if any?
At the moment, given the market backdrop, it would seem that even the fairly average manager – in some markets at least – may have a shot at delivering benchmark plus performance. And the best active managers can add significant value.
But. Yes, always a but.
If you’re tempted by active, there are a couple of things to think about before taking the plunge.
Active manager returns tend not to be persistent. Put another way, over any significant period, most managers will underperform their benchmark. If you want to take on the challenge of picking an active manager, the table below suggests3 that you’re best off focussing on small cap and maybe emerging markets and then doing your due diligence on a carefully selected shortlist. Take a look at Ian Gamon’s article for why small cap may be a suitable option for active management.
Source: S&P Dow Jones Indices, LLC. Data as at 31 December 2022.
And if the odds above don’t deter you, then consider that a 2018 paper4 highlighted that it’s typically a very small number of stocks that generate most of an index’s return (so maybe 2022 was the outlier in performance terms rather than the years that preceded it). Between 1926 and 2016 five stocks (Apple, ExxonMobil, Microsoft, GE and IBM) generated a tenth of all the US stock market wealth created, with the top 50 accounting for 40% of the total. Perhaps more soberingly, the same analysis indicated that more than half of 25,000 US listed stocks generated less than Treasury Bills. Passive gives you the certainty, active the possibility, of capturing a share of those outsized wealth creators. Place your bets please.
1 According to analysis carried out by Strategas Securities
2 LCP analysis of Morningstar data
3 Risk-adjusted, the numbers would look worse
4 Hendrik Bessembinder, Do Stocks Outperform Treasury Bills?, Journal of Financial Economics (2018)