By Daniel McGarvey, Portfolio Analyst
Flows into passive funds have greatly exceeded flows into active funds in recent years, largely due to cost concerns and the widespread belief that it’s easier to follow the index than to try to beat it.
There are certainly occasions when these arguments have merit, and there have been many years where most active managers underperformed, but current market conditions might ironically make equity indexation a riskier play. As shown below, the top five companies in the S&P 500 make up over 23% of its market cap, creating considerable concentration risk.
Diversification has been one of the strongest arguments for passive investing over the years, yet the country’s primary equity index is not well-diversified.
Most active managers would be opposed to holding 20% or more in 1% of the portfolio’s positions, making the top-heaviness of the index seem too aggressive for an average investor.
This concentration issue is especially notable for passive growth funds, given that the combined weight of AAPL and MSFT in the Russell 1000 Growth Index is nearing 25%. These heavyweight companies could continue to outperform, of course, but the concentration risk leads us to believe that risk-focused active management can add value in this environment.
Returns in April were positive for both stocks and bonds, with the S&P 500 returning 1.6% and the Bloomberg US Aggregate returning 0.6%. The 10-Year Treasury rate fell to 3.5%, and high-yield credit spreads narrowed to 4.5%, with the market expecting a terminal rate around 5.1% and no more rate hikes after May. One of the greatest factors affecting markets over the next few weeks will be the debt ceiling debate. With the House passing its bill, it appears that the question is less about whether the ceiling will be increased and more about how it will be raised.
Reaching an agreement will not be easy, and it is important to remember that austerity included in the final package could affect markets more than the probability of default, as was the case in 2011.
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Daniel is a Portfolio Analyst at Stonebridge Financial Group and works on portfolio analysis and other related tasks. When away from the office, Daniel spends his time playing guitar, reading, and exploring the outdoors.