US active managers tend to underperform when the top 50 mega caps outperform. William Fletcher of Independence asks if this is really the time to index the S&P500
Large Cap stocks have led the performance of a number of major world equity markets in recent years and certainly that has been true in the US. This preference results from a number of factors, including: desire for liquidity (due to huge dollar inflows), flight to safety (due to worldwide financial uncertainty), globalisation (as many multinationals aggressively pursued foreign markets), and merger-mania (seeking cost reductions and market dominance).
The enthusiasm for large cap stocks has resulted in a select number of issues dramatically outperforming the balance of the market. The largest 10% of the stocks in the S&P 500 over the past three calendar years produced 7.4% annualised incremental return over the other 450 stocks. The current P/E (based on 30 September 1998 price vs. IBES next year's earnings) is 27.7x for the top 50 and 14.5x for the next 450. In this environment, the majority of active managers have underperformed the S&P 500 index but outperformed the 450 stock subset over most of the past five years. This observation raises a number of questions: Why not index? What constitutes large cap ... just the top 10% of a large cap index? How long can this leadership continue? Historically, we have experienced cyclical markets. Will the future be different?
Stock prices are driven by earnings growth and relative price values. The market leaders have exhibited earnings growth and generally offer fine prospects for the future. The question is, do they offer attractive relative price values? The difficulty, of course, is that everyone has a different perception of what constitutes 'attractive relative value'.
We all have to answer these questions for ourselves, but perhaps the comments below can provide a framework for that thinking.
Indexing is an active bet ... and the timing is wrong!
The arguments in favor of indexing are certainly familiar to all of us - active manager returns vs the S&P 500, lower fees, and administrative simplicity. However, it appears that underlying most decisions to index is a sincere belief that indexing is a 'passive' decision - a default or 'risk-free' equity option. We respect everyone's right to make choices they feel are fiduciarily proper for their particular pool of assets. But we strongly disagree with the notion that indexing the S&P 500 is a risk-free, default, truly passive strategy. Furthermore, deciding to index the S&P 500 right now may be absolutely the wrong time to do so!
Indexing the S&P 500 is an active bet - it's only one of many possible subsets of the potential investable universe of stocks. And, as a portfolio, it has some very distinct embedded bets. Consider the following empirical evidence.
* The S&P 500 has a +2.1% tracking error vs. a broad universe of over 8,400 US equities.
* Of that +2.1% active risk, less than 20% comes from specific stock selection. Over 80% comes from industry and common factor bets like size (large cap vs. small), style (growth vs. value), and exposure to foreign income.
* By far, the biggest differences between the S&P 500 and the broader universe are that the S&P 500 has a mega cap bias and more exposure to foreign income. This is not surprising, given that the S&P 500 includes the very largest cap, multinational companies in the stock market.
* The S&P 500's beta and P/E ratio are now higher than the median manager's, a significant change from past experience.
(Tracking error and breakdown of residual variance are based on the BARRA FRMSU universe as of 9/30/98).
As a portfolio, the S&P 500 is not particularly diversified and, in fact, contains major active bets. So let's think of it as being just another portfolio, managed by a committee, which sometimes outperforms other portfolios and sometimes underperforms.
Why active managers have recently underperformed Everyone can recite the favorable competitive ranking of the S&P 500 relative to the various universes of active managers over the last three years to June 30, 1998. Let's explore a few reasons why this has occurred.
One reason is cash. In a dramatic 'up' market such as we've experienced during the last few years, holding cash - even a small amount - is a drag on investment performance relative to a fully invested index.
But cash is not the entire explanation of the up/down cycle phenomenon. Active managers tend to sell strong momentum stocks near the end of a rising market cycle. The bad news is that relative to indexing, they've sold too early. The good news is that they are less exposed to some of the market's greatest excesses going into the next cycle.
It's also very interesting to note that whenever the 50 largest - 'mega-cap' - stocks within the S&P 500 have outperformed the remaining 450 issues, active managers have underperformed. From 1987-1996, we observed a perfect year-by-year correlation between how the mega-cap stocks and active managers performed. Every year the 50 largest stocks within the S&P 500 beat the remaining 450, active managers underperformed the index; every year the 50 largest stocks trailed the remaining 450, active managers outperformed. Recent periods when active managers have lagged have all been mega-cap years. Prior to that, however, we had just come out of a three-year cycle (1991-1993) when smaller stocks within the S&P 500 outperformed, and the S&P 500 ranked in the bottom 30% to 40% of competitive universes. Last year, 1997, is an interesting period to look at in isolation. From January through June, the 50 mega-cap stocks outperformed the remaining 450 S&P 500 issues by 7.3%, and only 21% of managers beat the index. However, in the third quarter of 1997, the cycle reversed - the mega-cap stocks underperformed their smaller counterparts by 5.6%, and 68% of active managers outperformed the market. When market leadership is so narrow that the S&P 500's performance comes from such a small subset of its constituent stocks, active managers have a tough time keeping up.
Making an active bet on S&P 500...is this the wrong time? In today's market environment, an active bet on indexing the S&P 500 is a particularly large and courageous one. What makes indexing such an exceptionally big bet right now is that the S&P 500's performance is no different than any other 'active manager's' after having just had a wonderful performance run. The S&P 500's large active bet on the mega-cap, multi-national companies has indeed paid off - with only an occasional exception - since the beginning of 1995. But let's not confuse this outcome with passive or risk-free strategic conclusions. It was simply an active bet that worked in this particular time period. Looking at the S&P 500's performance between 1991 and 1993 shows exactly the opposite result: its embedded active bet didn't work.
Cycles, by definition, don't last forever. The change in the market's dynamics in that third quarter of 1997 when the market broadened enabled us to observe this once again. During this period, many of the seemingly invincible mega-cap stocks stumbled over turmoil in the Asian economies, fear of slowing exports, earnings disappointments, and anticipation of a less robust stock market ahead ... similar to the environment we are currently experiencing. Three to five years from now we may all look back and say, 'Gee, wasn't it obvious!' that eventually the mega-cap, multi-national market cycle would end. But in the meantime, let's not 'cloak' an active bet on this cycle continuing under the guise of a risk-free, passive strategy. Participation in large cap is an active decision to adopt a specific investment style.
William C Fletcher is chief executive officer of Independence Investment Associates, Inc. in Boston
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