Active managers have outperformed, but excess returns have compressed 

As illustrated in the following chart, excess returns in large cap stocks have historically been cyclical. While we believe this is still the case, it has become increasingly difficult for active managers to outperform the index. During the period prior to the Great Financial Crisis (GFC), the average top quartile manager in the large cap core space – the largest U.S. equity category – was able to generate a 3.32% excess return. However, since then, the average three-year excess return has compressed to just 1.35%. In addition to lower returns, the percentage of managers who have been able to outperform has decreased from 61% pre-GFC to 47% post-GFC. 

The compression of excess returns and number of managers able to outperform is, in part, attributable to the unique environment produced by unprecedented government stimulus. From December 2008 to March 2022, the Federal Reserve maintained the target fed funds range at zero for the longest period of time in history. The target rate reached a peak of only 2.37% in December 2018, before it was swiftly cut back to its historic low in early 2019. In addition to the low rate environment, the Federal Reserve enacted four tranches of quantitative easing to further spur economic growth.

This combination had notable implications for equity valuations and the broader U.S. stock market. The availability of low-cost borrowing kept many companies afloat, while lower discount rates of future earnings made the broader equity market more attractive. These market distortions created an environment where investing fundamentals were not the primary determinant of market performance. Thus, active managers were challenged to outperform. This trend prompted many investors to move their core allocations into passive strategies. As such, passive managers are now the dominant players in the large cap core category, with a current market share of 79.5%. 

Passive investing is not without its own risks

Even though excess returns remain compressed today, the market environment has changed. Interest rates are higher and market leadership is narrower, which has led to increased index concentration, now near multi-decade highs. This means that passively investing in the S&P 500 Index is an active decision, which introduces less obvious, but impactful, risk into portfolios. Investors who remain in passive may be caught off guard as we gradually move into a normalized rate environment – distinct from the zero-interest rate policy environment of the last decade – and see broadening of returns based on fundamentals.

As illustrated in the following charts, since the beginning of 2023, 86% of the S&P 500’s returns were attributable to the 10 largest companies in the index. Those companies dominating market performance now constitute 32.5% of the index’s market capitalization, significantly above the long-term average of 21.6%. Relative to the total index, this cohort is valued at a premium with its forward P/E ratio at 148% of the index level. Following this strong performance run, not only are valuations elevated but also analyst expectations are as well. Although it is true that these companies have generated strong earnings growth as a cohort, they are not monolithic. 

Conversely, the remaining 490 stocks in the S&P 500 are valued at 92% of the index level. This dislocation underscores the importance of active management for two main reasons:

• In a market with such extreme concentration, managers must be highly selective in their positioning to avoid the risk of being caught betting on yesterday’s winners.
• In a new interest rate regime with less capital liquidity, there will be greater differentiation of company performance, providing ample opportunity for stock selection in both the top 10 and the other 490 companies to drive returns.

With this inflection in market dynamics, active management should allow for investors to take advantage of both of these phenomena, while passive investing simply introduces hidden risks.

Leading active managers consistently outperform

Although active managers have been more challenged on the surface, leading managers continue to deliver healthy alpha for their clients. Historically, long-term equity returns are driven by earnings and dividends, while short-term returns are driven by P/E multiple expansion as a result of market sentiment, company news or emerging themes. An experienced active manager focuses on fundamentals – long-term earnings and growth – to drive stock selection and continually monitor risk.

What defines a leading active manager?

Despite headwinds for the active large cap core category, we believe the ability to utilize scale effectively, develop an integrated set of research capabilities and foster a strong culture enables us to be one of the leading active managers in the industry. At J.P. Morgan Asset Management, our global platform exemplifies and integrates each of those characteristics, which allows our active managers to uncover winning stock opportunities and deliver alpha to our clients over the long term.

With $835 billion in client assets under management¹, we are committed to using our vast global resources to produce the highest quality research.

• Our research platform, spanning four continents with 80 dedicated analysts covering 2,500 companies, provides our analysts with both a local and global perspective on the sectors they cover.
• With an annual global research budget of over $150 million, we are able to recruit top talent and provide our analysts with the best resources available. This investment in data and talent underscores our commitment to continuing to produce leading insights.
• Our large presence in the equity markets creates a unique level of access to company management teams, enabling our analysts to host over 5,000 management teams per year and share the insights they glean globally.
• To enhance the knowledge transfer process and create efficiency, we have a harmonized investment process. This means that our analysts and portfolio managers are speaking the same investment language, no matter what country they sit in.

Over the last four decades, we have developed an integrated set of investment capabilities, which generates leading bottom-up, research-driven insights. 

• We use a “Strategic Classification” assessment to consider the qualitative fundamentals of each company. The economics, duration and governance of a business are examined to limit risks that may be overlooked by a purely valuation-driven process. 
• We then have a five-year “Expected Return” framework to consider valuation. Each analyst uses their proprietary earnings and growth estimates to forecast company growth through the full business cycle to the end of the forecast period. This process derives a valuation multiple, which is then used to group each company in each sector into quintiles, from most attractive to least attractive. The “Expected Return” process creates a consistent valuation framework across the investment universe that is leveraged by our portfolio management team.
• Since 1987, our top ranked (undervalued) stocks have outperformed the market, while our bottom ranked (expensive) stocks have underperformed. 
  

Our culture is built upon the tenants of continuous improvement and partnership

• We consistently re-evaluate our processes and look for areas of improvement to avoid complacency. An example of a recent enhancement is the introduction of “Pre-determined Game Plans.” While launching coverage of a company, an analyst creates a one-page document explicitly summarizing the investment thesis, business thesis, thesis threats and potential signposts. This practice encourages honesty in the investment process and limits thesis creep.
• The partnership model between our analysts and portfolio managers further differentiates us from other managers. We treat the research analyst role as a career position, not a stepping stone. Our analysts manage risk in their own sector-specific portfolios and they are compensated as such. This cultivates more honest and curious conversations to drive our leading insights.
• Our portfolio managers are assessed on a blended 3-, 5- and 10-year performance metric, encouraging analysts and portfolio managers to commit to our process and maintain a long-term focus.