Active equity mandates fared better in 2021 than in prior years, as only 50% of managers underperformed their benchmarks last year compared to 55% and 65%, on average, over the past five and ten years, respectively. This performance trend offers hope for those championing the benefits of active stock selection.
Yet, while some may be rejoicing, the devil is in the details. And any exuberance is akin to New Orleans Saints fans being happy that the Saints had a winning record in 2021. Great, you won more games (9) than you lost (8), but you still missed the playoffs. And structural issues (for both the Saints1 and active mandates) may still hamper future performance.
In this charting the market, I will dive into the data to paint a fuller picture of the active equity market, beyond performance records, and suggest how to think about blending active with low-cost passive in 2022.
Out of the 2,117 active equity mandates spread across the major Morningstar categories (US styles, developed and emerging markets), 1,065 underperformed their prospectus listed benchmark in 2021 (a near even 50% hit rate). This is the lowest number of managers underperforming their benchmark since 2017, as shown below. And it is worth pointing out that any time this rate has fallen below 50% over the past decade, the next year’s performance figure is worse (2014, 2016 and 2018).
While 2021’s overall equity hit rate is greater than what we have seen in recent years, not all market segments fared the same, as shown below. A lot of the strength in 2021 was driven by US mid- and small-cap mandates. In both of those buckets, all three mandates (blend growth, and value) had less than 50% of managers underperforming their benchmarks. Those rates were better than the typical average, unlike some of the other key segments below.
For 2022, however, the small-cap alpha environment may not be as conducive given some of the market technicals we monitor. Correlations among small-cap stocks (meaning stocks’ movements are similar) are above averages and dispersion is below averages (meaning less opportunity for alpha due to tighter return differences).2 So some mean reversion may occur.
The strength exuded by, mid- and small caps is also evident when looking at the average excess return of managers, or the magnitude of outperformance. In 2021, the average excess return for small- cap mandates was 5%. This is the best rate in ten years and well above recent historical averages, as shown below.
Large caps and foreign large blend performed poorly compared to the most recent three- and five-year averages, with emerging market strategies having a worse rate than the three-year figure. And as shown below, the weak numbers in many of the categories resulted in the overall average excess return for all active equity funds falling below its three- and five-year average.
Value managers outshined growth in 2021. As shown below, all value segments had fewer than 50% of managers underperforming. In aggregate only 40% underperformed, compared to 62% of growth managers underperforming their benchmark last year.
The average excess return for growth managers was negative as a result, at -2.31%. Yet, that stat can be a bit deceiving, as small-cap growth managers had a 5% average excess return — much like how the Saints winning nine games in 2021 clouds the fact that they ranked third to last in the league for offense efficiency.3
Most of the overall weakness in growth, both share of underperformers and negative excess returns, is from large-cap growth, where 86% of managers underperformed by a lot. The average excess return was -7%. For value, however, the average excess return in 2021 was well above historical averages (+1.36% versus -1.38% and -1.21% three- and five-year averages) — positive for the first time since 2017 and for only the third time in the past decade.
We also witnessed a stylistic performance trends match in concentrated factor baskets versus traditional plain vanilla value/growth styes. A pure value basket beat S&P 500 Value by 10% while a pure growth exposure underperformed S&P 500 Growth by 3%.4 As a result, one could theorize that the more “active” decisions within the style, even from a factor perspective, the stronger/weaker performance versus traditional measures and benchmarks. The performance trend of value over growth styles for 2021 may carry over to 2022.
While performance trends were, in aggregate, better than prior years, the after-tax profile of these active managers was once again detrimental to the actual investor experience – and worse than usual. In 2021, 87% of all equity funds (~1,800) paid a capital gain. That figure is elevated versus the historical trend, as the average percentage of managers paying capital gains over the last three- and five years is 79% and 75%.
Now some of those managers outperformed their benchmark. So, there may be less sting from capital gain dividends. Yet, 917 (44% of all managers) not only paid a capital gain, but also underperformed their benchmark. Therefore, not only were pre-tax excess returns negative for half of all invested strategies, but on an after-tax basis the results were even worse for significant number of them. And the fees paid to earn those results were not cheap either. The average fee charged by the managers that underperformed their benchmark AND paid a capital gain was 1%.5
It’s worth noting that these capital gains trends differ when considering the type of vehicle used to access active mandates. Only 16% of active equity ETFs paid capital gains in 2021, compared to 88% for mutual funds. And when you run the screen based on the percentage of active ETFs that underperformed AND paid capital gain, it is 10% of ETFs versus 44% for mutual funds, as a lower share of ETEF mandates paid capital gains and a greater of ETFs share beat their benchmark (59% versus 50%).6
Fees were also lower on active ETFs (0.64% versus 0.96%),7 adding another reason to consider ETFs for active allocations. Although active ETF strategies are not as plentiful as with legacy mutual funds, the ETF universe continues to expand. In fact, 211 new active equity funds were launched in 2021.8
With the data above there are five key takeaways investors should be aware of for 2022:
Ultimately, mixing in active with low-cost passive ETFs continues to be a sound strategy in building resilient and efficient portfolios. And an analysis of historical trends strongly points toward avoiding large caps when allocating a portfolio’s fee budget.
1 I’m not bashing the Saints on purpose, they just fit the theme here. But I do think they need to get a better QB and trade Michael Thomas.
2 “US Mutual Fund Performance Update”, January 4, 2022 BofAML Global Research Equity and Quant Strategy.
3 Again, nothing against the Saints. Just fit the narratve. Offense Efficency defined by Successful Play % per sharpfootballanalysis.com.
4 Based on the performance of the S&P 500 Growth Index, S&P 500 Value Index, S&P 500 Pure Growth Index, and S&P 500 Pure Value Index as of December 31, 2021 per Bloomberg Finance L.P. data.
5 Morningstar as of December 31, 2021, per calculations by SPDR Americas Research.
6 Morningstar as of December 31, 2021, per calculations by SPDR Americas Research.
7 Morningstar as of December 31, 2021, per calculations by SPDR Americas Research.
8 Morningstar as of December 31, 2021, per calculations by SPDR Americas Research.
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
The S&P 500 Value Index is 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.
S&P Pure Growth Indices includes only those components of the parent index that exhibit strong growth characteristics, and
weights them by growth score.
S&P Pure Value Indices includes only those components of the parent index that exhibit strong value characteristics, and
weights them by value score.
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