For one type of investor, 2022 was the best year in a long time. A large number of active managers of equity mutual funds—the ones who select specific stocks rather than track an index—beat the S&P 500.
Measuring the relative performance of fund managers is trickier than it sounds, so not all the data are in. (Number crunchers have to decide which index each fund can be fairly compared with.) But early indications show that a key group of stockpickers eked out an edge. According to an analysis by advisory company Strategas Securities, 62% of active large-company “core” funds—those that buy a mix of growth and value stocks—beat the market. That’s the highest percentage of active portfolios to notch a win since 2005.
Similarly, an analysis by S&P Dow Jones Indices, which compiles a widely followed scorecard of active versus passive funds, showed that almost half of a broader universe of large-cap active funds topped their benchmark in the first half of 2022, compared with a long-run average of only 35%. Final 2022 figures are still in the works, but “if the whole year came out that way, it wouldn’t shock me,” says Craig Lazzara, managing director of core product management at S&P DJI. Most managers still lost money, but as the S&P 500 index tumbled almost 20% last year, a lot of them found ways to at least limit the damage.
This development seems to affirm a favorite marketing line of fund companies: When times get tough, active management shines. Even a 50-year proponent of index investing, Princeton emeritus professor of economics and A Random Walk Down Wall Street author Burton Malkiel, acknowledges that “there has been a tendency for active to underperform somewhat less in declining markets.”
Still, stocks have more up years than down ones, and such bright moments for active managers have tended to be few and brief. “In the 21 complete years for which we have data, the majority of large-cap managers outperformed the S&P in three years. The last one was 2009,” Lazzara says. It’s not necessarily that managers are bad at their job. Fund fees (a typical 0.63% of assets per year for active equity funds versus 0.08% for index funds) drag returns down. So they have to be above-average before costs to have a shot at even being average.
In times of disruption, though, professional investors can sometimes find themselves on the right side of a new trend. In the bullish decade prior to 2022, the simplest way to make money was to keep riding the same winning stocks, something that index funds do automatically. But the past year saw an abrupt shift from bull to bear and from high-valuation growth companies to bargain-price value stocks. “Essentially, the buildup to valuation bubbles favors passive, and the popping of those bubbles favors active,” says Scott Opsal, director of research for the Leuthold Group, an investment researcher.
By August 2020, the five largest companies by market value accounted for almost 25% of the S&P 500, the highest concentration in top names since at least 1980, according to data from Goldman Sachs Group Inc. Concentration stayed high and finally bit index investors in 2022. Big tech names that tend to be near the top—including Amazon.com, Microsoft and Tesla—fell hard last year.
Active funds often had less exposure to these names. “The fact that many managers simply do not hold the top 5 companies at the same weight as the [S&P 500] has been accretive to portfolio performance” in 2022, the Strategas report found. That may be partly the wisdom of managers, but there were also institutional factors. Many active funds have limits on what percentage of assets they can hold in one stock or one sector, so they can’t mirror the makeup of an index that comes to be dominated by a handful of stocks even if they want to.
Also, even those funds that buy a broad mix of stocks may have had a stylistic tilt toward value investing that helped them as tech stocks were punished. “When most people talk about indexing, they’re thinking of the S&P 500 or the total stock market index,” says William Bernstein, an investment writer and co-founder of Efficient Frontier Advisors. In years when value does better, some active managers have an improved chance of beating those two broad benchmarks. But the same can be said of the many index funds that track value stocks. For example, the Vanguard Value ETF fell only 2% last year. It tracks an index of about 350 stocks that are cheap relative to their earnings, sales or assets, and it lists conglomerate Berkshire Hathaway Inc. as its biggest holding.
Another reason active funds may outperform passive index funds at turning points in a market has to do with cash reserves, Malkiel says. Both active and index funds keep cash on hand to meet client redemptions. But to accurately track their benchmarks, index funds generally use futures contracts so that the fund remains effectively fully invested at all times. Thus a declining market hits 100% of an index fund, but if an active fund has 5% in cash, only 95% of the portfolio is dragged down.
Bryan Armour, director of passive strategies, North America, for Morningstar Inc., gives an example of how that cash difference would play out for the average active stock fund holding 3% of its portfolio in cash versus the media passive exchange-traded fund holding 0.19%. With the Russell 1000 index of the biggest companies losing about 19% in 2022, active managers picked up an extra half a percentage point of performance by virtue of their cash holdings. That’s almost enough to wipe out the drag from the funds’ typical fees. “That’s a big advantage that is unlikely to be explained by manager skill,” Armour says.
Even if you think active funds’ advantage as a group last year is likely to repeat, you face another question: How do you pick the one that’s most likely to outperform? “When you find a manager who is above average in a particular year, that does not predict whether they will be above average the subsequent year,” says S&P DJI’s Lazzara. Lazzara reads the data as an argument for sticking by indexing, but Strategas takes a different lesson from its numbers. Its report notes that 2022 was the best year since 2010 for an index that equally weights each stock, when compared with the S&P 500 index, which weights stocks by market value. In other words, a large number of stocks did better than the biggest, most popular ones. Something similar happened in the wake of the dot-com bubble, and Strategas argues that as the pandemic fades and interest rates rise, stockpickers may have a better shot of outperforming as the market shifts away from what worked in the recent past.
A more basic takeaway is that a seemingly plain-vanilla index such as the S&P 500 is still plenty risky, and choosing to index isn’t the end of your important portfolio decisions. Investors who find an S&P 500 index fund more volatile or growth-focused than they’d like can look for passive funds with a value tilt, which still have a cost advantage over active. Besides funds that specifically track bargain-priced stocks, there are funds that hold stocks in equal weightings or that weigh by factors such as price, dividends or earnings consistency rather than sheer size. But anyone who was shocked to see their index fund lose 20% could also consider a slightly lower weighting in equities overall.
Indexing doesn’t always win; it simply has better odds most of the time. Even in volatile markets, that’s probably enough if you also have an asset allocation plan you can stay with.Read next: After 30 Years, the King of ETFs Faces a Fight for Its Crown
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