One of the most powerful trends in the investment world over the past decade has been the relentless rise of passive-index investing. Accelerated by the explosive growth in exchange-traded funds (ETFs), by many accounts passive investors now hold 40% or more of shares of U.S. stocks.
But a funny thing happened in 2022: The performance of actively managed funds relative to passive indexing staged a dramatic comeback. For example, half of active fund managers outperformed the S&P 500 Index in 2022, according to Morningstar, by far the highest share in more than a decade (by comparison, in 2021, just 25% of active managers beat the benchmark). In value investing, 70% of active managers beat the Russell 1000 Value Index in 2022; about half of active growth managers bested the Russell 2000 Growth Index, the best relative performance since 2013. In short, active stock-picking is back!
The Achilles Heel of Passive Indexing
We can posit some reasons for the turnaround in fortunes in 2022. For years prior to last year, in an environment of aggressive Federal Reserve money printing and its lax monetary policy, everything, including the most speculative investments, seemed to go up: A high tide lifted all boats. Investors, in essence, bought beta—the market—and were less interested in the alpha that can be generated by adept managers researching and investing in individual securities.
Also consider the distorting nature of market capitalization-weighted indexes such as the S&P 500. When investors buy the index, they’re indiscriminately purchasing shares of hot stocks that power the index regardless of valuation and not due to sound security analysis. What happened in 2022, when Russell 1000 Growth plunged by almost 30%, is very reminiscent of the market crash of 2000 when the tech bubble burst. For example, in 2022, Meta Platforms and Tesla, two mega-cap darlings plummeted by about 65% in one year; Amazon.com and Nvidia both lost around 50% of value. Since these deflated mega-cap stocks had high weightings in market-cap-weighted indexes like the S&P 500 and Russell 1000 Growth before 2022, they dragged down the overall performance of the indexes (the price-weighted Dow Jones Industrial Average, by contrast, outperformed the market-weighted S&P by 10 points last year).
We are not predicting the demise of index investing, but interestingly, the late John Bogle, founder of Vanguard Group, and the father of the index fund, grew nervous about the implications of his invention. Writing in The Wall Street Journal in November 2018, just weeks before he passed away, he said, “What happens if it becomes too successful for its own good?”, noting that the vast bulk of index funds and ETFs are managed by only a handful of giant institutional investors. “It seems only a matter of time until index funds cross the 50% mark…I do not believe that such concentration would serve the national interest.”
Active is Awakening
Just when active, qualitative, fundamental investing appears to be staging a rebound, there is arguably a shortage of qualified analysts. Wall Street banks have slashed the number of sell-side analysts and research budgets over the past 20 years due to declining broker commissions, perceived conflicts of interest with their investment-banking arms, and the rise of indexing and quantitative investing conducted by machine. Many small-cap stocks, for instance, now have no research coverage.
Such a vacuum favors seasoned stock-picking analysts and fund managers—people with the skills and experience to conduct due diligence and deep research on companies and who possess the ability to scrutinize balance sheets and cash flows in this year’s climate of rising interest rates, slowing economic growth, elevated inflation, potential credit downgrades, and reduced liquidity. Last year, Value outperformed Growth by more than 20 percentage points (as measured by the returns of the Russell 2000 Value and Growth indexes), which could be a harbinger of a value-investing cycle after the style spent years out of favor. A long-short value fund, with the ability to invest in the winners (the strong growing stronger) in today’s landscape and the means to sell short the perceived losers (the weak getting weaker) could be an appropriate strategy to add alpha to a portfolio in 2023.
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