Why Active Large-Cap Equity Funds Could Outperform

The global economy is fraught with risk as Russia’s invasion of Ukraine enters a new phase. At the same time, rising interest rates have made a recession almost inevitable in the United States. As a result, investors may want to remain defensive with their portfolio allocations rather than deploying cash back into growth stocks or junk bonds.

 

Price-earnings ratios remain historically elevated for large-cap stocks, but they’ve come off their recent highs. Source: Multpl

Higher interest rates have reduced the price-earnings ratios of expensive stocks, particularly large-cap equities in the tech sector. But with the economy slowing, central banks could be reaching the end of their hawkish surprises. And the price-earnings ratios of these companies could stabilize over the remainder of the fourth quarter.

As a result, U.S. large-cap stocks could be an attractive option. With overweight exposure to defensive sectors, like healthcare and software, they are less sensitive to changes in the economic cycle. The strong U.S. dollar has also helped these stocks outperform global averages in local currency terms (e.g., translating foreign returns into U.S. dollars).

Actively-managed funds tend to outperform when market returns are erratic or negative. After all, when benchmark correlations are low, they can add value through stock picking or sector rotation strategies. They can also add value by limiting portfolio concentrations when the largest stocks in benchmark indices lag behind the rest of the market.

 

Active managers tend to outperform when benchmark indices are more concentrated. Source: Investment Executive

Over the past several years, the S&P 500 index has become more concentrated in a handful of stocks. In fact, the 10 largest stocks account for more than one quarter of the index. According to a T. Rowe Price analysis (above), excess returns were significantly higher for managers in the top quartile following higher index concentration.

 

Active managers also tend to outperform when valuations are high. Source: Investment Executive

A similar analysis (above) found that U.S. large-cap active managers generated more substantial excess returns when valuation levels were high. After all, they can underweight large and expensive index components and overweight undervalued ones. Or they can at least selectively overweight large components and act as a filter.

 

Data as of November 1, 2022.

The S&P 500 index rebounded in October but remains about 20% lower since the beginning of the year. With global risk at elevated levels and a U.S. recession on the way, investors may want to consider shifting their portfolio allocations back into large-cap stocks as a defensive play. And history suggests that actively-managed large-cap funds could outperform.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.