Don’t call it a comeback, we’ve been here all along.

Actually, you could call it a comeback if you look at the recent numbers. Active equity investing—aka fundamental active management or stock picking—enjoyed a bounce-back year in 2022. According to Lipper Analytical Services, roughly 66% of large-cap value managers beat the Russell 1000 Value Index in 2022, while an estimated 98% of small-cap value managers beat the Russell 2000 Value Index.  

That’s a start, but what about 2023 and beyond? An argument can be made that an environment of higher interest rates, persistent inflation, and slower economic growth will result in a high dispersion of returns among individual companies and investment styles. As a result, active management, and value-oriented active in particular, might be positioned to deliver on its goal of excess returns.

Passive Pitfalls
What’s behind a possible active management renaissance? One factor might be the fact that passive management has become a victim of its own success. It was recently reported that passively managed index funds have surpassed their actively managed counterparts in U.S. stock ownership, with an estimated $2 trillion moving from active to passive strategies over the past decade, according to data from the Investment Company Institute (ICI). 

Some market pundits have openly questioned the ramifications of having so much money in passive index funds being managed by only a handful of giant institutional investors. That type of concentration might have unintended consequences. At what point is that too much of a good thing? 

He was referencing the fact that the bulk of index funds and ETFs are managed by only a handful of giant institutional investors, which leaves a lot to be desired in a world increasingly dominated by group think. “I do not believe that such concentration would serve the national interest,” Bogle explained.

It’s important to remember that as investors pile into funds based on cap-weighted indexes (i.e. passive investments) like the S&P® 500, they are indiscriminately purchasing more and more shares of the largest stocks that have been powering returns. At the start of 2022, for example, the top 10 companies in the S&P 500 represented more than 30% of that index. Many of these were tech companies that incidentally were among the worst performers last year as interest rate policy changed. This was a rude realization for many passive investors.

It’s not just the inherent structure of cap-weighted passive investments that might have tipped the scales in favor of active managers. Consider that prior to 2022, companies enjoyed an extremely accommodative Federal Reserve monetary policy, and many investments—including more speculative non-earning companies, crypto assets, NFTs, and SPACs—headed higher. Investors, in essence, were happy buying beta (the overall market). All that has changed now and investors may once again prioritize managers who can generate alpha (the excess returns versus a benchmark).

Another factor has been the way Wall Street banks have slashed the number of sell-side analysts and research budgets over the past 20 years due to declining broker commissions, perceived conflicts of interest with their investment-banking arms, and the rise of indexing and quantitative investing. The case is especially evident in the small-cap arena as fewer analysts cannot adequately cover the universe of smaller companies. In fact, many small-cap stocks have no research coverage at all, which can lead to distortions between true value and stock price. This is precisely where an active equity manager should be able to excel.

Active Manager Considerations
If investors agree with the premise of an active equity management rebirth, it becomes a matter of choice. Before allocating new money, it’s important to look at investment philosophy and approach, as well as the ever-important costs. Here are some considerations before allocating to an active manager:

• This year’s climate looks to offer a mix of elevated interest rates, slowing economic growth, inflationary pressures, potential credit downgrades, and reduced liquidity. Value-oriented stocks with improving returns could be positioned to participate in any rising market, while also acting as a volatility buffer should sentiment take a turn for the worse.
• Is your value manager focused on income and earnings, or company balance sheets and cash flow statements? Both are important, of course. However, our team's experience has found that the market is excessively fixated on income statements and quarterly earnings expectations. We believe this is short-sighted as income statements do little to reveal a company’s true financial health and longer-term prospects. Moreover, balance sheet and cash flow statements are less vulnerable to management manipulation and offer the best opportunities to uncover signs of financial improvement or decay, in our opinion. 
• When diving into a company’s balance sheet, it’s important to analyze its integrity from both an accounting and a market value perspective. It’s also important to look beyond the GAAP financial statements and examine regulatory filings and statutory statements when available. By analyzing regulatory statements of an insurer, for example, we are often able to estimate whether the company has been overly aggressive in setting their liability for policy reserves. In general, we prefer a high degree of conservatism in both the marking of assets and liabilities. 
• Consider managers who are not afraid to stray from the benchmark—indicated by high active share of a fund. After all, if you are allocating to an active manager, you don’t want to settle for mirroring the index. Tracking error is another metric that can illustrate if an active manager is a chronic “benchmark hugger” or has a high conviction in its stock picks. A financial advisor may be able to use these and other metrics to help identify an active manager that can help investors achieve their goals.