For more than a decade, indexed-based mutual funds and ETFs have been dramatically capturing market share at the expense of actively managed funds. Financial advisors, money managers, individual investors, and 401k participants en masse have perpetuated this trend without fully grasping their role, let alone the implications.

The day of reckoning is drawing near. The fundamental underpinnings of the financial markets have begun to break down. Long-term tenets have given way to a herd mentality that is blindly steering us at best into inevitable underperformance, and at worst, an impending crash.

In order to rise above the malaise, one must fully open their eyes to what is going on around us. Only then may one begin to see the fallacies so widely expounded as truths. The current state of the markets is a mirage, and one can either choose to fall for it or learn how to play the game the right way.

If all you do is follow the herd, you’ll just be stepping in poop all day.

Dr. Wayne Dyer​
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The Game

The game as we know it is seemingly predicated on the age-old debate between active and passive investing. For more than a decade, passive investments have experienced dramatic inflows, while actively managed funds have suffered significant outflows.

In 2019 alone, actively managed equity funds experienced $204 billion of outflows, while passive funds garnered $163 billion of inflows. 

 

Cumulative Flows for Active Vs. Passive Equity Funds

Index-based strategies have grown in popularity in large part because active managers have rarely outperformed indices (they also typically cost considerably less). Standard & Poors tracks the performance differences between active managers and their benchmarks in their semi-annual SPIVA Report (S&P Indices Versus Active).

As you can see from S&P’s most recent SPIVA Report, across all market capitalizations and investment styles, whether you’re looking at the trailing 1, 3, 5, 10, or even 15 years – the vast majority of active managers have failed to outperform their benchmarks.

Chart Data on Percentage of U.S. Equity Funds Outperformed by Benchmarks

On a superficial level, it’s easy to see why so many investors have gravitated to passive investing, but therein lies the problem. According to a report published by CNBC back in 2019, passive investing now controls nearly 50% of the domestic equity markets, up from around 25% a decade ago. As this trend continues, the share prices of individual stocks become dislocated from their appropriate valuations, as passive investing has a propensity to reward the largest stocks in the index. We are already seeing that now!

As an example, the S&P 500 is currently comprised of 505 individual stocks. The index itself is capitalization-weighted, meaning the larger companies make up a larger percentage of the index. After more than a decade of massive inflows into passive funds tracking the S&P 500, the top 5 stocks now make up nearly a quarter of the index, and the performance of those 5 stocks has now severely skewed not only the returns of the S&P 500, but the market as a whole.

The five largest stocks in the S&P 500 are Apple, Microsoft, Amazon, Facebook, and Google (we like to call them the “Fab Five”). The performance of an equally weighted basket of these 5 stocks together over the past several years has generated outlandish returns – particularly in comparison to the index itself, or more appropriately the average stock in the S&P 500.

To put this in perspective, over the trailing 1-year period ending August 31, 2020, the Fab Five generated nearly an 80% rate of return, while the S&P 500 was up almost 22%, and the average stock in the S&P 500 (represented by the S&P 500 Equal Weighted Index) was only up 8%. Since our pre-Covid high on February 19th, the S&P 500 is up nearly 5% – but as you can see, this is due almost entirely to the near 37% return generated by the Fab Five. After all, the average stock in the S&P 500 is still down more than -4%.

S&P 500 Returns Chart

When you look at where the returns are coming from in the S&P 500, it is clear to see the game is rigged, and the largest stocks are surely being artificially propped up by the vast sums of money chasing after passive returns and buying indices. At a certain point, this becomes a death knell for investors, and you don’t want to be the last one buying at the top, only for things to come crashing down.

Winning by Playing the Game by Different Rules

The definition of insanity is doing the same thing over and over again and expecting a different result.

– Albert Einstein

The dramatic underperformance by active managers, along with the proliferation of passive investing, presents a myriad of challenges for financial practitioners. Should they choose to adopt an asset allocation-based approach for their clients comprised of low-cost, passive indices, net of fee, their investors are highly likely to underperform.

Worse yet, as this practice becomes more and more commonplace, the perception of the advice and acumen provided by advisors becomes commoditized. Yet, practitioners utilizing active managers to fulfill an investment allocation for their clients seemingly face a statistically improbable task of picking winning strategies. Either way, this seems to present a lose-lose proposition.

The aforementioned quote has often been attributed to Albert Einstein. Now whether or not he actually ever said it is not the point; more importantly, the question is, “Why is it that the vast majority of money managers continue to manage money the same way when that methodology has proven over decades to be highly improbable of generating any measure of outperformance?” That certainly sounds like insanity to me. 

So, what is it that these money managers do that doesn’t seem to work? Money managers commonly base their investments to large degree on the index itself. They remain mindful of the sector weightings of their respective benchmark and choose to make incremental under or overweight positions around it. They also often own larger weightings in the largest stocks in the index. Remarkably, many of those tasked with doing due diligence on investment strategies actually reward this approach, highlighting statistical measures such as tracking error or r-squared as being more favorable when a strategy moves more like their benchmark. How does that make any sense? If your ultimate goal is to beat your benchmark, why would you try and look like it? Is it not common sense that you’d probably want to take the opposite approach? Apparently not. Especially when you consider the performance that would be required to overcome the higher fees charged by these “active” managers; at which point, they hardly stand a chance. 

The good news is you don’t have to play the game by those rules. Instead, you can choose a path that dramatically increases your statistical probability for outperformance. While there may be many different ways to accomplish this, there are three in particular that we believe stand out. In order for an active manager to significantly increase their probability of generating consistent outperformance we believe one needs to: be tactical, remain sector weighting agnostic as opposed to their benchmark, and invest with a relative degree of concentration.

Bar Chart of Rules to Outperform the Markets

What it Means to be Tactical

A good tactical investment strategy aims to align portfolio holdings and underlying risk with prevailing market conditions. This is the antithesis of a traditional “buy and hold” approach to investment management (or “buy, hold, and pray” as we like to call it). The reality is that as the markets ebb and flow, at times it is to your advantage be more opportunistically allocated, while at others it is imperative one take a more defensive position. 

In a long-only equity strategy, one may either reduce risk by raising cash or lowering the overall beta of the portfolio (favoring more defensive sectors of the market). Some strategies may even do both. 

Bar chart showing investment gains needed to recover from market losses

From our experience, the most efficient means by which to employ a tactical strategy is to focus on achieving long-term outperformance by mitigating downside risk during more adverse market conditions. If one can manage to reduce exposure to large market declines, one need not fully capture the upside of the markets. The opposite approach would be to attempt to outperform by taking on more risk than the markets, which if ill-timed can often lead to outsized losses and a far less smoother ride for investors.

Being Sector Weighting Agnostic vs The Benchmark

Active management should start with investing in the right sectors and end with buying the most attractive stocks in those sectors. Regardless of what percentage a benchmark has in a given sector, if the fundamentals are not constructive, why own it? 

This approach may be incongruent for those looking for investment strategies to track in lockstep with their benchmark, but the reality is you can add significant value and alpha to long-term performance by allocating a higher percentage of the portfolio to sectors currently under expansion and reducing exposure to those under contraction (or avoiding them altogether).

Bar chart of Portfolio Investments

Investing with a Relative Degree of Concentration

It is not uncommon for active managers to maintain an equity portfolio of 50-100 stocks or more, with the idea that a large number of stocks increases diversification and therefore decreases portfolio risk. The reality is, this could not be further from the truth. In fact, research has proven that holding a portfolio of more than 20-25 stocks does nothing to reduce portfolio risk and volatility.

Chart of Portfolio Diversification Decay

Additionally, by holding
more than 20-25 stocks in
a portfolio, one significantly
reduces the potential to
generate outperformance.

Risks of Diversification Chart

The Bottom Line

Just because one has always done something a certain way doesn’t make it right, particularly when it comes to portfolio management. If decade after decade, we’ve observed a persistent struggle by active managers to outperform their benchmarks, why is it more people aren’t asking themselves why that is? Or what could be done better? Instead, it seems as though our industry has thrown in the proverbial towel and copped out, choosing instead to simply “buy the index”. Yet in doing so, not only do they essentially guarantee underperformance net of fee, perhaps more alarmingly they diminish their value. The next generation of investors will not continue tovpay for something they can easily do on their own. Technology, information, and the resources available to individual investors today has dramatically narrowed the knowledge gap. 

At the same time, as investors continue to pile into indices, we are unknowingly creating a massive dislocation between the performance of the largest stocks in the index and the average stock. Exactly how that ends, no one can say for sure, but it’s easy to see how if this continues as it has over the past decade, we could very well be creating a potential bubble of epic proportions. 

If you take the big picture view, this isn’t hard to see. After a decade of record inflows into passive investments, and record outflows out of actively managed strategies, we’ve created arguably the most inefficient market anyone alive has ever seen. Like all extreme divergences in the market, this too will come to an end. Rather than bear the brunt of this impending misfortune, for those “woke” to what is going on around us, there is a better way. 

Instead of following the herd blindly, one can make a conscious decision to avoid stepping in the poop (as Dr. Dyer so eloquently put it): to carve out their own path and ultimately provide their clients with what has become an increasingly rare opportunity to win the game.