Years of cheap money helped fuel an historic bull run that swelled passive index vehicles—until rising inflation, tighter monetary policy and petering growth crashed the stock party in 2022. As we’ve said over previous months, we believe we’ve entered a new economic regime marked by higher rates and resurgent economic volatility—a fundamental reversal that, in our view, calls for even more thoughtful and selective portfolio positioning. In this paper, we discuss four major unfolding trends that equity managers have been historically well-positioned to exploit.
Introduction
In 1974, Vanguard founder John Bogle launched the First Index Investment Trust, which allowed retail investors to track the entire S&P 500 Index at minimal cost. Three decades later, passively managed assets comprised roughly one-sixth of all equity assets under management (see chart below).
But the passive revolution really took off after the 2008 financial crisis, as low interest rates drove trillions of dollars into stocks, much of it flowing into passively managed funds. Today, passive assets account for 45% of the equity market, a staggering advance over such a short stretch.
Passive Management Takes Flight In An Unprecedented Era of Low Interest Rates
Source: Federal Reserve System, SimFund, and Factset. As of 1/08/2023.
Despite the rise of passive management, we believe this set-it-and-forget-it mindset can underperform when money isn’t as cheap, risk premia aren’t as low, and economic cycles aren’t as long and cooperative. Ultimately, we believe these fundamental shifts play to the strengths of long-term active management.
One big reason, in our view, is the greater influence of a small sliver of large, growth-oriented companies within cap-weighted indices. For example, a look at the Russell 1000 Growth Index shows that 14 years of easy money have led to concentration levels not seen since the excesses of the 2000 dotcom bubble (see chart below). We think increased concentration can thwart diversification and exposure to optimal factor, sector and style tilts warranted by the broader business cycle.
Passive Indices Have Grown More Concentrated
Source: Neuberger Berman Research and FactSet. Data as of January 25, 2023.
Rising concentration is also glaringly apparent when looking at the weight of U.S. companies within global equity indices. As shown in the chart below, market capitalization of U.S. stocks accounted for roughly half of the MSCI World Benchmark before the 2008 financial crisis; today, U.S. stocks command a dominant 70% share of the global benchmark.
The U.S. vs. the Rest of the World
Source: Neuberger Berman Research, MSCI, and FactSet, as of 1/17/2023.
That’s why we believe the market may be entering a new golden age for disciplined managers who aim to generate alpha by identifying mispriced individual stocks and navigating broader—and choppier—macro shifts.
Specifically, we believe equity allocators now have an attractive opportunity to take advantage of four potential long-term trends:
- The flight toward even better earnings quality. Over the last six decades, companies with lower operating margins tended to underperform their more profitable peers; likewise, companies that relied on more aggressive accounting techniques suffered relative to their conservative competitors. We believe extra aggression is likely to earn extra punishment in both the current downturn and over the longer horizon.
- Cheaper companies over growth stories. Value stocks outpaced high-flyers for eight decades until easy money flipped the script. We believe higher domestic inflation and a potentially weakening U.S. dollar (now at historic highs) will likely usher in a period of global reflation which, in our view, often bodes well for value stocks.
- Smaller companies over large players. Similar to the long-term value-vs.-growth trend, small caps typically edged out large caps until the 2008 financial crisis. In our view, historical valuation differentials and dollar cycles now imply that small caps are ready for a revival.
- Non-U.S. over U.S. As the dollar weakens, non-U.S. developed markets (as well as emerging ones) tend to outperform.
We explore each of these four trends in the following sections. And for a quicker, graphical representation of the first three, please see the chart included in the Appendix.
