Home Runs: Part of the Cycle

Active/passive cyclicality is further demonstrated with high and low amounts of stock “home runs”—that is, a stock that outperforms the benchmark by 25% or more. Markets that feature large amounts of home runs signal dispersion in stock returns. High dispersion should benefit active managers who can single out the winners, whereas a low number of home runs indicates stocks are moving together, which typically benefits passive management.

In FIGURE 3, we’ve ranked the past 35 years from highest to lowest in terms of which stocks within the S&P 500 Index had the most home runs. The average number of home runs during this time period was 219. Sure enough, in years that feature a high number of home runs, active tended to outperform. And when there were fewer standouts, passive was the clear winner. It’s just another example of how the performance of active and passive management has remained faithful to cyclical trends.

Active, Passive, and an Market Cycles

So what does cyclicality in active and passive management performance mean for you as an investor? We believe it demonstrates the importance of maintaining perspective and minimizing the undue influence of fickle market sentiment as you navigate changing market cycles. Instead of letting recent performance enchant you into chasing returns, you should instead consider current market conditions and what the future could hold.

Despite a bear market in 2022, equities have generally risen for more than a decade (FIGURE 4).² Not only that, the value of the S&P 500 Index has grown more than 467% since its low in March 2009.³

At the individual sector valuation level, the S&P 500 Index has a 20-year average price/earnings ratio (the ratio of a stock’s price to its earnings per share) of 16.2. As of December 31, 2022, the price/earnings ratio was 16.8. FIGURE 5 illustrates that 7 out of 11 sectors in the S&P 500 Index are trading at a premium relative to their 20-year historical average. Active managers have the flexibility to consider valuations when choosing stocks, while passive investments can’t use valuations as a consideration.

While bull markets can last quite some time, they’re not immune to occasional corrections (as measured by a loss of 10% or greater) to help keep them healthy. Like speed limits on highways, market corrections are a necessary evil in investing, but not one to be feared. They keep markets from becoming overinflated and prevent valuations from reaching heights that lead to damaging crashes. They can also provide opportunities for active management.

Active Management Has Fared Better During Corrections

The most recent market correction arrived in August 2022. When corrections occur, you may not want to be exclusively invested in passive. Instead, you may want to consider investing in actively managed funds.

There have been 27 market corrections over the last 33 years. FIGURE 6 shows that during those corrections, active outperformed passive 20 times, with an average rate of outperformance of 1.29%.⁴ Again, we compared active to passive by removing index and enhanced index funds from the Morningstar Large Blend Category to represent active, and used the S&P 500 Tracking Index category to represent passive.

By allowing investors to respond to ever-changing markets, active management empowers investors to maximize opportunity as conditions demand. But if you’re invested in an index fund, you could be exposed to significant downside due to single-sector performance. For example, during the collapse of the dot-com bubble in 2000, active management outperformed passive significantly, -0.41% to -9.44%. Much of the blame for passive’s underperformance during that period can be laid at the feet of a single sector.

As FIGURE 7 shows, the technology sector made up 28% of the S&P 500 Index at that time. The sector (as represented by the S&P 500 Information Technology Index) crashed hard, to the tune of a 38.72% decline in 2000.

Meanwhile, the average active manager was underweight technology relative to the index (24% vs. 29%), which helped limit the damage done to their portfolios when the tech bubble burst. Active managers with a positive return during this time were more underweight to technology with a 14% average weighting, and those with a negative return hewed closer to the index with a 29% average weighting.⁵ Likewise, in 2014 when oil prices dropped significantly, passive investors were hurt by their inability to reduce exposure to an underperforming sector.

When bull markets inevitably turn, passive managers could be left holding stocks and sectors with poor fundamentals and inflated valuations. Meanwhile, active managers have the ability to help mitigate risk by reducing exposures to expensive areas that will be hit hardest, and conversely, increase exposure as sectors or asset classes recover to capture upside as the new market cycle begins.

Investment Implications:

This insight focused on active vs. passive investing in the Morningstar Large Blend category because it’s widely believed to be the most efficient category—the one that should invariably favor passive investing. Yet even this category shows the cyclical nature of active and passive performance. The same cyclicality is present in other investment categories such as mid-caps, small-caps, and global/international equities.

Just as we think declaring active management dead is premature, we don’t contend that active management is the only suitable choice for investors. Far from it. We believe that the choice between active and passive management is not a zero-sum game, but that each has a place in investor portfolios based on the individual needs and wants of the investor. With that in mind, here are some conclusions to take away from this piece:

• The performance of active and passive management has been cyclical—each style has experienced extended periods of outperformance.
• When evaluating active and passive management, looking beyond recent performance and measuring active share is important.
• As we saw in 2022, market corrections are inevitable and a common occurrence in equity markets over time.
• There have been 27 market corrections over the past 33 years, and active management outperformed passive management in 20 out of 27 corrections.
• During market corrections, the flexibility of active management allows for reducing exposure on the downside and ramping up exposure to capture alpha⁶ in the early stages of recovery.