Coming into the second quarter, more than 50% of active US equity managers were outperforming their benchmarks in six out of the nine traditional US style box segments. Given that only three areas had that high of a hit rate in 2020, this year was shaping up to be a bounce back for active. That is, until the tide turned on some of the factors that are conducive to active outperformance: correlations and dispersion.
This turning of the tide within equity differs from the performance of active fixed income mandates, however. Unlike equity, the majority of active managers are still beating their benchmark on the year within fixed income.
In this charting the market, I will dive deeper into these performance trends and explore what to consider when constructing blended active and passive portfolios for the second half of 2021 and beyond.
A low correlation across assets indicates the return environment is more differentiated and not clustered. High return dispersion (disparity between winners and losers) indicates alpha generation opportunities may be abundant, provided managers overweight the correct exposure.
In Q2, both metrics were not overly favorable for active managers. For stocks within the S&P 500, pairwise correlations came in just slightly below average in Q2. However, dispersion fell to the bottom 3rd historical percentile. Within mid caps and small caps, correlations registered levels roughly in line with long-term averages and dispersion also fell well below average levels.1 With neither of these metrics entirely favorably, this presented headwinds — with dispersion likely the greater driver given correlations are still “near” averages.
A similar trend of falling dispersion was witnessed when moving up a level to sectors. As shown below, dispersion was steadily increasing in Q1 sector. In late April, however, dispersion started to decline and came close to approaching long-term averages before turning higher in the last few days of June. Both single stock level and sector dispersion falling clearly created a headwind for active equity managers to continue their pace from Q1 into Q2.
With the above headwinds, manager performance noticeably turned in Q2, as shown below. Only one segment had more than 50% of managers beating their benchmark last quarter (small-cap growth), down from six in Q1. As a result, the other eight posted negative average excess returns for Q2, averaging -62 basis points across the segments. The weak quarter pushed the average excess return for managers in 2021 down to just 20 basis points from 63 basis points at the end of Q1, a 67% decline — a trend in line with how only three segments now have more than 50% of managers outperforming on the year.
US Active Equity Manager Performance
The largest quarter-over-quarter decline in performance was from mid-cap value managers. After posting an 80% hit rate in Q1, only 30% of managers beat their benchmark in Q2. The average excess return in Q2 was a negative 90 basis points — more than a 400 basis point difference from Q1. Yet, this was not the worst excess return for the quarter; mid-cap growth managers posted a negative 149 basis point figure, as only 24% of managers beat their benchmarks. It was a tough quarter for mid-cap managers irrespective of style, to say the least.
While there was consistency of weak performance across mid caps, there was no consistency among style exposures. Value managers largely underperformed, with large-cap value nearly eclipsing a 50% hit rate. Yet, there was a noticeable difference among growth managers, given the performance by small-cap growth mandates.
Following a 36% hit rate in Q1, 70% of small-cap growth funds beat their benchmarks in Q2, posting a style box best 92 basis points in average excess returns. This performance trend also contradicts what we saw at the index level, where growth styles bested value in large- cap markets, but not small. Value worked better in the small-cap market, outperforming growth by 143 basis points in Q2.2 Perhaps the active manager performance in small-cap growth, therefore, reflects a bit of the segment’s style drift (i.e., owning value names in a growth strategy).
The impressive 70% of managers beating their benchmark in the small-cap growth category is rarely seen. Based on 20 years of data, this is the fifth- best hit rate ever (i.e., 70%-plus hit rates occurred only 6% of the time). In fact, anytime more than 65% of managers beat in a quarter, the following two quarters saw only 46% beat.3 And the average excess return turned negative (-23 basis points).
Diving a bit deeper, only three of the top decile funds this quarter were in the top decile in either of the past three quarters, signaling the moves were perhaps largely idiosyncratic and not from a persistent trend. This can be confirmed when examining the attribution of this quarter’s top decile funds.
When grouped into a portfolio where each top-decile small-cap growth fund is equally weighted and the excess return versus the S&P 600 Small Cap Growth Index is separated into factor and non-factor (i.e., stock specific or idiosyncratic) components, the strong excess returns are from idiosyncratic factors, as shown below. Now, this is what you want to see from an active manager, where stock selection skills, and not factor tilts, are driving returns. However, combined with the limited number of these managers who were in the top decile in previous quarters, I am a bit cautious of how sustainable this large outperformance will be — not to mention the past trends of weaker performance in the ensuing quarters following a strong hit rate.
US Small-Cap Growth Top Decile Excess Return Attribution
The trends in fixed income are the opposite of those in equities, considering that all bond segments listed below had more than 50% of managers outperforming their benchmark in Q2. While not shown, the trends are consistent within intermediate muni, corporate, and multi-sector bond categories.4 Given this strength, only one segment (emerging market bond) does not have more than 50% of managers outperforming on the year, thanks to a dismal Q1.
Intermediate core-plus managers have the highest rate so far in 2021, with 90% of managers outperforming and with an average excess return of 1.01%. These returns include active fixed income ETFs, a segment that has continued to grow assets.
Fixed Income Active Manager Performance
The outperformance for core-plus mangers is likely due to the strong returns from credit markets, and how the benchmark (Agg) does not have a significant amount of credit weighting — and no below investment-grade exposure. As shown below, there is a 93% correlation between positive intermediate-core plus excess returns and broad high yield outperforming the Agg. This historical relationship is holding today. Nonetheless, active core fixed income is enjoying strong returns this year — improving upon the 74% hit rate in 2020.
Core-Plus Manager Quarterly Excess Returns
Given the outlook for potentially higher (but still historically low) rates and a possible increase in bond market volatility this summer from a further evolution of post-crisis policies likely kicked off at the Jackson Hole symposium, active management may add value for the rest of the year. Active management’s flexibility and depth of options are two valuable traits in this market.
Right now, the environment for active US equity mandates is less favorable than it was at the start of the year. Also, the strong performance by a cohort of small-cap growth managers may not be entirely sustainable over the next few quarters and should be examined further at the single fund level before any allocation is made to gauge persistence.
Looking ahead to the rest of the year, given the strong return dynamics and supportive market environment, it may make better sense to use your fee budget on active fixed income strategies — particularly in the core — rather than on active US equity mandates. However, understanding the drivers of return will be helpful in fixed income, assessing if the excess return is coming from three parts (sector selection, security selection and duration management) rather than from just one factor (owning high yield). I explore this topic further in my whitepaper on portfolio construction for the next decade.
Check out more charts like the ones in this blog in our monthly chart pack.
1 Bank of America Merill Lynch, US Mutual Fund Performance Update, July 2, 2021.
2 Bloomberg Finance L.P., as of June 30, 2021 based on the performance of the S&P Small Cap 600 Growth and Value Index returns.
3 Bloomberg Finance L.P., Morningstar as of June 30, 2021.
4 Morningstar, as of June 30, 2021.
Bloomberg Barclays US Corproate High Yield Bond Index: A rules-based, market-value weighted index engineered to measure publicly issued non-investment grade USD fixed-rate, taxable, corporate bonds.
Bloomberg Barclays US Aggregate Bond Index: A rules-based, market-value weighted index engineered to measure publicly issued investment grade USD fixed-rate, taxable, bonds.
S&P Small Cap 600 Growth and Value Index: A market capitalization weighted index. All the stocks in the underlying parent index are allocated into value or growth. Stocks that do not have pure value or pure growth characteristics have their market caps distributed between the value & growth indices.
The views expressed in this material are the views of SPDR Americas Research Team and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.