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  • Chip Rewey

The Case for Passive Has Eroded

According to Bloomberg, passive investing accounts for almost 54% of all domestic equity funds and roughly 1/6th of the total domestic equity market, with most of these funds tracking the S&P 500 and other broad U.S. indexes. The move by investors to passive versus active has been dramatic, growing its share of U.S. fund assets by 2.3% annually since 2013. *

In our view, the move to passive has been driven by several factors, including the lack of differentiation from large cap active funds that attempt to track and minimize performance differences from the large cap indices. We think these concerns are valid, we see no added value in a fund designed to mimic an index.

However, we also believe that the strong performance of the large cap growth investing styles vs. the small and value style of investing has been the preeminent driver of the move to passive and created a false confirmation bias among investors that large cap passive is a superior investing style vs. all other strategies. (See chart below, sourced from Bloomberg.)

We believe the dramatic quantitative easing by the U.S. Federal Reserve has been the overwhelming driver of large cap growth outperformance. Due to this Fed easing, growthier companies that show low or negative cash flows can still be valued richly in discounted cash flow models, due to low interest rates. With a low and likely mis-applied weighted cost of capital (WACC), businesses that hemorrhage cash can still be modeled with high price targets, but with most of the value residing in the post 10-year projected terminal value.

Value Outperformance Likely in the First Inning

With Fed easing now close to finished and most economists projecting rapid rate hikes, we think the DCF driven outperformance of large-cap growth is likely over. Since November 30th, the day Fed Chairman Powell finally capitulated to higher rates and retired the word ‘Transitory’, the small and smid cap value indices have strongly outperformed the large cap growth indices.**

We think the move in small and smid value is only in the first inning. The Fed has yet to raise rates, or even cease buying bonds under their quantitative easing program. (See chart below, source Bloomberg).

The Case for Passive Has Eroded

The myth that large cap passive strategies offer diversity is currently unfolding as well. As seen in the chart below, the top five positions in the S&P 500 account for over 20% of the index (over 22% if we count Alphabet as one company, and not two separate share classes). The top 10 positions account for over 28%, and this is after Meta (FB) has plunged 41% year to date.*** (see our blog “Mind the Gap” where we warned on the downside risk of momentum technology

When Active Works

In our view, passive investing will likely not be as successful in smaller cap strategies as it has been in large cap growth.

The universe of domestic equities with market caps between $100 million and $10 billion is over 6,800, vs. 196 companies over $50 billion.**** Passive has worked in large cap strategies, in our view, due to the limited universe of large cap companies. However, as shown above, the sheer number of small and smid companies means smaller passive vehicles hold low concentration in their top positions. The top 10 positions in the Russell 2000 Value ETFs represent approximately 5% of the index, and many names in the universe are not even in the index.

Active Research and Concentration Can Differentiate in Small Cap

With a large number of companies and no dominant weightings in ETFs, we think an active approach to small and smid cap investing can outperform ETFs. With a universe of over 6,800 companies, we believe active research can add value in small and smid cap. Strategies that follow a philosophy similar to our RAM philosophy of 1) Financial Strength, 2) Ability to Grow and 3) Discounted Valuation, aim to identify companies with ability to outperform the average performance of the small and smid universe.

The Rumors of the Death of Active are Greatly Exaggerated

The factors of low rates and limited choices that drove large cap ETF success are eroding. In our view, as investors rotate to small and smid value, they should focus on well researched and concentrated portfolios, a differentiated approach versus the small cap ETFs. This value-added research approach, when combined with a concentrated and disciplined portfolio construction methodology, is designed to deliver investment results over the smaller cap indices.

Assumptions are based on current beliefs and are subject to change based on many factors including, market and other conditions. There is no guarantee that forward-looking statements will come to pass. This information should not be construed as a recommendation of any specific security or investment type. Please see additional important disclaimers



***FB performance YTD 2022 sourced from Bloomberg as of 2/23/22 close.

****Number of domestic companies by market cap ranges sourced from Bloomberg.


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