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US mega-cap dominance drags active managers: Frontier
Active managers are more sensitive than ever to valuation risk. But in recent times it’s been a case of “go big or go home.”
In recent years, Frontier has noted a narrowing in the breadth of US equity market return drivers, and short-term extremes of the same, with just a handful of tech mega-cap stocks accounting for around 51 per cent of returns for the calendar year to May 2021. Active managers who have grown increasingly sensitive to the valuations of those stocks are likely seeing performance suffer as a result.
“Since 2017, the combination of underweight positions in Microsoft, Apple, Amazon, Alphabet, Meta and Tesla has detracted from global equity managers’ relative returns against the MSCI ACWI Index,” wrote Frontier analyst Brad Purkis for the firm’s latest Frontier Line report.
“Of note is how strong this effect was during 2020, with the rolling 12-month total effect peaking at just below -2 per cent. 2020 was a year of considerable volatility in markets and at the time Frontier observed a considerable spread of active management outcomes.”
While active managers once took a neutral view on those companies, their ascendancy in the index has made more and more managers leery. The same phenomenon can be observed in the history of smaller domestic markets, with active managers forced into decisions about whether to own certain businesses just to keep up, but the increased representation of the US market in the global indices has seen the problem wrought large.
Purkis notes that in 2011, the US shared a relatively equal part of the overall index with other developed markets –  42 per cent and 44 per cent respectively –  with emerging markets making up the balance at 14 per cent. Since then, US markets have grown their share of the overall index to 60 per cent. Â
“Since 2011 we have observed both increased earnings and P/E expansion within US markets. This can lead to increasing risk in markets associated with high valuations, especially if earnings growth does not continue to meet or exceed investor expectations,” Purkis wrote.
“While many global active managers pride themselves on being able to assess opportunities from wherever they may arise, and having a globally diversified portfolio, the increased weight of US markets within the MSCI ACWI Index creates benchmark risk for managers looking elsewhere for opportunities. Alpha outcomes for active managers are being increasingly driven by US markets.”
And given the under-representation of active managers in the handful of stocks he describes, Purkis thinks it’s ETFs – particularly thematic ETFs, focused on “internet, innovation, and technology” – that are “picking up the slack”. ETFs now represent some $10 trillion of AUM (around 15 per cent of all fund assets globally) and thematic ETFs have raked in more than six times the funds of the next highest sector based ETF.
“The key point that needs to be made… is that ETFs are largely constructed without any reference to the price of the underlying security. Given the high portion of retail investors within ETFs we can assume there is far less valuation sensitivity when compared to the institutional investment landscape of global active managers,” Purkis wrote.
“While not the sole reason for the under-ownership amongst global equities managers, we believe a significant portion of this can be attributed to the increase in ETFs FUM and in particular thematic ETFs where the group of six mega-cap US stocks feature prominently. This increase in popularity, especially in the past three years, is likely to have contributed to the increasing index weight of these companies in global indices.”
But Purkis believes the decline in active management returns is cyclical rather than structural and that “a potential unwinding of market concentration could provide a more conducive environment for active management”, as it did in the five years to December 2006 following the dot.com bust.
“While the prevalence of passive investing and popularity of ETFs is something that may continue to grow, we do not expect it to continue in such a narrow breadth as it has done recently,” Purkis wrote.
“While it is difficult to attribute specific drivers to overall excess returns trends and infer future outcomes with certainty, we believe the global equities universe can continue to deliver an alpha profile in-line with historical outcomes of around 1-2 per cent before fees over a long period of time.”
