The quick rollout of the vaccination programme, another massive round of economic stimulus, and a dovish Fed have paved the way for a strong recovery in the US economy in 2021. The yield curve has steepened as a result, with the ten-year US Treasury yield more than doubling off its low. This has caused investors to begin to pivot away from some of the largest stocks in the S&P 500 as well as other hyper-growth stocks -- as cost of capital is up -- into the equities of companies that are likely to see a significant recovery in earnings tied to the economic recovery this year.
The performances and valuations for these mega-companies and other large-cap growth stocks may have peaked. Large-cap growth stocks have strongly outperformed their value counterparts for almost 15 years, reaching historic levels in 2020. Additionally, growth stock valuations reached historic extremes relative to value stocks last year. This performance and valuation trend started changing in 2020, when investors began rotating to long-neglected value and cyclical stocks based on improving economic growth forecasts and appreciating commodity prices. Active managers have been outperforming during this value rotation, due to their positions in value and cyclicals, and we believe that trend should continue.
Active managers have been outperforming during this value rotation due to their positions in value and cyclicals, and we expect that trend to continue.
As shown in figure 2, the rotation out of the five largest stocks has contributed to the equal-weighted S&P 500 index outperforming the capitalisation-weighted S&P 500 index, which is dominated by the largest five stocks.
In addition to the S&P 500 equal-weighted index starting to outperform the capweighted index in aggregate since late-2020, additional research results show that the equal-weighted version of ten of the S&P 500 sectors outperformed their cap-weighted counterparts so far in 2021, while the degree of cap-weighted outperformance in energy and healthcare -- the two exceptions -- was very minor (see figure 3). This suggests that we are in the initial phase of a broad-based value rotation spanning the sector spectrum.
We are in the initial phase of a broad-based value rotation spanning the sector spectrum.
Is history repeating itself?
As the concentration in the S&P 500 index has begun to decline, active managers have started to outperform. On 24 February 2021, Bloomberg reported that a recent Goldman Sachs study of 507 actively managed mutual funds focused on US stocks -- representing approximately $2.7tn of assets under management -- determined that roughly 57% of large-cap mutual funds have outpaced their benchmarks in 2021 thus far. This marks the strongest start to a year for active managers in almost a decade. We believe that the current rotation could continue without a disruption, similar to what investors experienced following the dot.com bubble.
We believe that the current rotation could continue without a disruption, similar to what investors experienced following the dot.com bubble.
This is similar to the performance of active managers leading up to, as well as after, the previous peak in concentration of the S&P 500 index in 2000. The S&P 500 capitalisationweighted index outperformed the equal-weighted S&P 500 index from 1995 through 1999, as the index became more concentrated. After the dot.com bubble burst and index concentration plummeted, 59% of active US large-cap funds outperformed their benchmarks from 2000 through 2005 as investors rotated out of the technology, media and telecommunications names that had driven market concentration during the 1990s. Not only did the equal-weighted S&P 500 index outperform the capitalisation-weighted index over the period, but it also outperformed each year. During the same five-year period, the capitalisation-weighted index return was consistently below the median return of the Morningstar Large-Cap Blend universe. Today, even if we are not in a correction akin to the bursting of the dot.com bubble, the potential for a secular rise in interest rates should persuade investors to rotate away from longer-duration assets, such as mega-caps stocks, towards shorter-duration stocks like value and cyclicals.
We believe active managers may have the ability to continue to outperform for the following reasons:
- The economic recovery is likely to be sustained by pent-up consumer demand, further increases in government spending on infrastructure and healthcare, and accommodative monetary policy. This should result in a broad-based and durable earnings recovery, which should contribute to increased market breadth.
- The S&P 500 index is more concentrated than it was at the previous peak in 2000. As of end-2020, the top-five stocks accounted for 22% of the S&P 500 compared with just over 18% in 2000. This means the index should have further to go compared to 2000 in reaching a more normal level of concentration.
- The Biden administration is focused on environmental and social policy, which, we believe, will make it increasingly important to distinguish between companies that are addressing ESG risks and those that are not. Active managers who integrate ESG into their investment processes can make this distinction.
- Finally, astute active managers are able to make allocation decisions across sectors, industries and other portfolio characteristics in anticipation of potential macro opportunities, such as a value rotation or cyclical recovery. These managers can target areas of the market most likely to generate above-benchmark performances in different market environments.
In light of the Biden administration’s focus on ESG, it increasingly important to distinguish between companies that are addressing ESG risks and those that are not.
Dispersion is increasing
Dispersion of stock returns and the correlation of those returns are further important indicators of the opportunity for active managers to outperform. Historically, there has been a positive correlation between the dispersion of returns and the outperformance of active managers relative to their benchmarks. This means that active managers typically outperform when dispersions are elevated while a passive approach performs better when there is a lack in return dispersions. Similarly, higher correlations among stock returns tend to favour passive investments while lower correlations tend to favour active ones. Currently, return dispersions are elevated and correlations are trending down from near-historical peaks, both of which are favourable for active.
We believe ESG is another critical consideration for today’s asset owners. As such, investing with an active manager who are able to research fundamentally and assess qualitatively company managements’ socially responsible behaviour and can interact with company management to improve ESG principles is critical in today’s world. With a strong economic recovery in sight, we believe that the market should continue the rotation out of the narrow cohort of mega-cap market leaders and that we are entering a market environment that offers opportunities for managers employing an active approach, as evidenced by the greater market breadth, elevated dispersions and lower correlations. We believe that active managers may continue to benefit for some time as excessive concentration levels in US equities unwind. In this environment, and at a time when there is increasing pressure on investors to act more responsibly (ESG), we believe that asset owners should consider allocating to managers actively investing into US equities.
We believe that the market is set to continue the rotation out of the narrow cohort of mega-cap market leaders and that we are entering a market environment which is more constructive for managers employing an active approach, as evidenced by the aforementioned greater market breadth, elevated dispersions and lower correlations.