Will Active Management Shine in 2023? A Look at Last Year’s Trends

• About 63% of active equity managers beat their benchmark in 2022, the best hit rate in 15 years.

• Active value funds had the greatest depth, but large- and mid-blend managers’ average excess return was highest in 15 years.

• Only three bond fund categories had better-than-average hit rates and higher-than-usual average excess returns in 2022.
  

Proponents of active management say funds that don’t track an index are positioned to outperform when markets are volatile and decline. While it’s true that some active categories set performance records in 2022, there were also pockets of weakness.

Big picture? Equity strategies had stronger hit rates (percent of funds outperforming) and average excess return figures than active bond funds, which posted their weakest results in five years.

But the real question is, what do last year’s active management performance trends mean for portfolio construction decisions in 2023?

Active US Value and Blend Funds See Best Results in 15 Years

In 2022, roughly 63% of all active equity managers beat their benchmark, the best hit rate in 15 years and well above the historical average of 45%.

This also marks the first time in 15 years when more than half of the active equity universe had positive alpha in back-to-back years, since 59% of active equity funds beat their benchmark in 2021.

Where exactly did active management shine in 2022?

• 70% of US Blend and 83% of US Value funds outperformed their prospectus benchmarks — their highest hit rate in 15 years, and well above averages of 42% and 46%, respectively.
• Four out of the six blend and value styles had record-setting hit rates.
• 88% of Mid-cap Value funds outperformed, the highest hit rate of all in 2022.

2022 also marks the second consecutive year that more than 60% of value and blend managers beat their benchmark, a feat not seen in 15 years.

But that outperformance didn’t translate to overseas or growth funds. In all non-US and growth categories, fewer than 50% of managers outperformed in 2022. In fact, emerging markets (EM) and all three growth market cap profiles saw double-digit percentage decreases to their long-term average.

For EM this breaks a three-year stretch of more than 50% of managers beating their benchmark. Given the idiosyncratic turmoil within EM, from the Russia-Ukraine war to China’s zero-COVID policy, this isn’t a surprise.

Active Equity Average Excess Returns also Elevated

Excess returns for Value and Blend funds were well above their historical averages, as shown below. In fact, both Large Blend and Mid Blend categories posted their highest average excess return in 15 years, 1.49% and 2.40%, respectively.

This strength stems from value’s strength as a factor/style and the long-standing value bias many core blend active managers have. Pure value stocks beat the S&P 500 Index by 16.1% in 2022, the most since 2009.¹ At the same time, pure growth stocks underperformed the S&P 500 the most since 2002.²

Small Value had the largest excess return, at 5.33%. The remaining two value disciplines rounded out the top three, upending the Purity Theory’s premise, which states that the style in favor (in this case, active value) usually leads to stronger performance for the opposite of that style (in this case, active growth) due to the style drift of the latter.³ The performance of active growth managers also challenges the Purity Theory.

If the value factor continues to perform well in 2023, strength from that bias and focus could lead to similar strength for blend and pure value managers this year — not to mention any smart beta multi-factor strategies that use value as an input, or even specific single-factor, value-oriented smart beta funds.

3 Active Bond Fund Categories Outperformed

While many equity categories had record-setting performance in 2022, active bond funds overall had a lackluster year. Roughly 40% of managers outperformed their prospectus benchmark. This is the lowest rate since 2018 and 11 percentage points below the historical average — typically, more than half of bond managers beat their benchmarks.

Only three categories had better-than-average hit rates and higher-than-usual average excess returns in 2022: EM, high yield, and multi-sector bonds.

The lesser-constrained multi-sector bond funds produced the best results. More than 77% of multi-sector active managers beat their benchmark one year after 96% of managers had, as shown below. The remaining six categories saw below-average performance, with less than 50% of managers beating their benchmark.

Average excess returns were similar to hit rate trends, as only the same above three markets saw positive average excess returns in 2022. And, once again, multi-sector bond funds delivered the strongest results, with an average excess return of 1.95%.⁴

This breaks a streak of outperformance for Intermediate Core-Plus managers. In five of the last six years, more than 70% had beat their benchmark. The last time less than 70% of Intermediate Core-Plus managers outperformed was in 2018, a year not unlike 2022, when rate and credit volatility were both elevated.

But I don’t believe weakness in those core segments should deter investors in 2023. After all, following 2018, for three straight years more than 70% of Intermediate Core-Plus funds outperformed, with an average excess return of 82 basis points a year.⁵ Also, strictly confining the core of your portfolio to Agg-based bonds is limiting. It’s also risky, given the prospect for higher rates ahead and how duration effects have been the sole driver of negative returns.

While only 31% of active managers beat the benchmark, 51% did have lower realized volatility than their prospectus benchmark in 2022⁶ — an example of how active duration management, sector allocations, and security selection may be able to better defend against rate and credit volatility than vanilla indexed core Agg bonds.

Will Active ETFs Outperform in 2023? Watch for Market Breadth

Active management’s strong 2022 results are likely to spur more interest in active strategies, something we’ve begun to see in the ETF market.

Active ETFs took in $100 billion of inflows last year.⁷ Yet, some of those were into defined-outcome, option-based strategies that target a more convex payoff and aren’t solely focused on delivering alpha. Nevertheless, we’ll likely see a proliferation of active funds and inflows this year — perhaps even in the mutual fund industry.

That said, equity strategy trends are facing a mixed backdrop that wouldn’t normally create a conducive environment for alpha.

In both US large and small caps cross-sectional stock dispersion is below average, while pairwise correlations are above average.⁸ This signals a clustered/macro-driven market where there is little difference among stock co-movements, making it challenging for active to outperform consistently.

Because this could upend the recent trend of active equity outperformance, anyone planning to use only active equity strategies in 2023 may want to rethink their approach. After all, the saving grace for alpha in 2022 was market breadth.

In 2022, 56% of US stocks beat the broad index return, a rate above the long-term average of 49%.⁹ With more stocks beating the index, chances for a correct overweight position to add alpha improve. As a result, breadth will be a very important metric to watch if active stock-picking patterns from 2022 carry over into 2023 — and if there will be a three-peat of more than 50% of equity managers beating their benchmark.

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