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The S&P 500 Index Funds Group dropped from the top rank on the Asset Class Group Scores Page; however, it remains in the 97th percentile. This prolonged and historic strength from the domestic benchmark can easily mute the sector shifts taking place beneath the surface. So, to help pinpoint these trends more closely, we used the quadrant graph.

As a reminder, the quadrant graph is particularly useful for gaining a visual perspective on the relative strength/relative risk profile of a fund group. The two-dimensional graph, like any other, has an X and Y axis, with the former representing rRisk and the latter representing fund score - an rRisk of 1 matches the 3-year monthly standard deviation of the S&P 500, and a fund score of (3.00+) is considered technically acceptable. Keep in mind that fund scores will increase when the security performs well and decrease when the security performs poorly (like other momentum rankings). As a result, optimal quadrants include 2, which indicates low relative risk and high relative strength, as well as 1, which indicates high relative risk and high relative strength.

When grouping a set of funds, like we did below with the State Street SPDR Sector ETFs, we can summarize this trend, or demand sentiment, through the slope. A positive slope tells us that higher risk investments are being rewarded with higher returns (risk-on) while a negative slope says that lower risk investments are demonstrating greater price resilience (risk-off).

Perhaps of greater use is the ability to compare points in time. Shown above is the snapshot of the SPDR Sector quadrant graph from June (6/4) while the below snapshot is yesterday's (8/4) setup. Notice that we are also using the Doppler RS view, which tells us the intensity of the score directions/movements of the funds at the time. Two months ago, we had a positive slope and an environment where higher rRisk groups were being rewarded, but now (8/4) we have a negative slope, indicating that lower rRisk areas have held up better. Although the current slope is not strongly negative, it should tip us of shifts taking place in the underlying market environment, which can be masked by the major indices hitting all-time highs week after week.

As we do periodically, today we revisit the debate of active vs. passive management with updated rankings through the end of the second quarter.

Supporters of passive management assert that active managers cannot consistently outperform a passive benchmark and therefore investors are better off to invest in lower-cost index funds. Meanwhile, those in the active camp maintain that through their analysis and expertise active managers can produce persistent alpha.

The key determinate of which strategy, active or passive, is superior is market efficiency. Market efficiency describes the degree to which asset prices quickly and rationally adjust to reflect new information. In a highly efficient market, any new information is quickly incorporated into prices and therefore it is not possible to consistently achieve above average risk-adjusted returns in this type of market. Therefore, due to their lower cost, passive investment strategies are favored over active management in a highly-efficient market. In less efficient markets, on the other hand, the opportunity exists for skilled active managers to outperform passive strategies, thereby adding value for clients.

The question of active vs. passive is often framed with the premise that active or passive is always superior and often focuses on the U.S. large cap equity market, which is a natural starting point for the discussion – the large cap U.S. equity market is composed of the most well-known companies in the world and represents a large portion of many retirement portfolios. However, if we stop there we ignore what should be an obvious and fundamental element of the discussion – the various markets around the globe are not all equally efficient. The very fact that U.S. large cap companies are the most visible and researched firms in the world suggests that the U.S. large cap equity market is likely to be more efficient than its less-well-known counterparts!

Although it may appear largely academic, the active vs. passive debate has real-world implications for you as an advisor. First and foremost, you want to do what is in the best interest of your clients to help them achieve their financial goals. So, if active management really does not add value, and you will best serve your client by using passive funds to reduce expenses, then so be it. On the other hand, utilizing only passive funds eliminates one of your value propositions as an advisor – evaluating and selecting funds – and removes any possibility of outperformance. Therefore, we’ll examine several different markets individually to get a feel for which are the most efficient, and therefore likely favor passive management, and which are the least efficient, and therefore provide the greatest opportunity for active managers. The tables below show the rolling five-year return rankings of several well-known indices (representing passive management). If the index ranks in the top two quartiles, then it outperformed most managers within the peer group during that period. Conversely, if the index ranks below the 50th percentile, then most active managers in that universe outperformed the benchmark.

US Large Cap Equity

While there have been short periods, like the first quarter of 2021, during which the S&P 500 SPX has underperformed the average active manager, over longer periods, active managers have clearly struggled to outpace the passive benchmark. Over every rolling five-year period in our lookback window, the S&P has ranked above the 50th percentile. This does not rule out the possibility that individual mangers have consistently outperformed the index, but, in each time period the S&P has outperformed the majority of active managers. Put another way, if we had two hypothetical portfolios, one that held the S&P and one that randomly selected an active manager each period, we would expect the S&P portfolio to outperform.

US Small Cap Equity 

Anecdotally, we have heard that 2021 has been challenging for active small cap managers amid the rallies by Gamestop GME, American Entertainment Holdings AMC, and other stocks with weak fundamentals that were generally eschewed by professional managers. This may, at least partially, explain why we have seen the benchmark climb above the 50th percentile in the most recent time periods, while it had ranked in the third quartile during most periods ending before 2020. At this juncture, it would be hard to say whether active or passive management is clearly favored. The recent underperformance by active managers is something to keep an eye to see if it is merely a short-term trend confined to an unusual market environment or if develops into something more long-term.

Developed International Equity

The passive EAFE index finished below the 50th percentile in almost every five-year period shown indicating that on average active management has been able to add value. Based on the historical evidence, we would expect to benefit by utilizing active management in the space as opposed the passive benchmark.

Emerging Market Equity

Similar to what we saw in the small cap space, the MSCI emerging markets index has finished above the 50th percentile over the last several time periods after ranking in the bottom two quartiles in many periods prior to 2020. Once again, this is a development worth keeping an eye on to see if it is short-term in nature or persists to become a long-term trend.

US Core Fixed Income

The US aggregate index ranks squarely in the bottom quartile across most time periods in our lookback period leaving little doubt that most active managers outperform the benchmark. It is worth noting that there are number of ways that active fixed income managers can subtly alter their portfolios – e.g. reducing Treasury exposure and increasing corporate exposure – to gain a return advantage over the index. But doing so also increases the risk (credit risk in this example) of the portfolio. The point being that while most US core fixed income managers are outperforming the benchmark, many may be doing so by marginally increasing risk.

Global Fixed Income

As with domestic fixed income, the rolling five-year rankings also show consistent outperformance by active managers. 

Ultimately, whether active or passive management is better comes down the individual market in question. There are several markets in which active managers show consistent outperformance. There are also more efficient markets, like US large cap, in which active managers have struggled to outperform the index. Making a market-by-market assessment when deciding whether to employ an active or passive strategy provides us the opportunity to save money on fees by utilizing passive strategies in highly-efficient markets and add value by identifying inefficient markets and selecting skilled active managers who can generate superior returns. 

The latest seasonal evaluation for the Fund Score Method (FSM) models on the NDW platform took place after market close on Tuesday, August 3, and any corresponding trades were sent out the morning of Wednesday, August 4. As a refresher, the FSM seasonal models are evaluated four times a year at the beginning of each seasonal quarter, so at the beginning of February, May, August, and November. At each evaluation, the models will sort their respective inventories by fund score, seeking to only hold those funds that possess the highest scores. The number of securities held is dependent on the model, but will typically be two or five names. For more information on the construction of the FSM models, please visit our FSM model guide.

This week’s evaluation saw several changes to the models, but perhaps not as many as might be anticipated given the recent market movement. None of the separate cash triggers that are tied to the models were triggered, as the core US equity market continues to rank among the top asset classes by average score, and money market continues to sit at the bottom of the rankings. Many of the models that saw changes shifted back toward overweight positions in large-cap growth, with high exposure also seen in the technology sector. Today, we will review the recent changes to some of the equity-focused models available on the platform, with the remaining models being covered in Friday’s Fund Score Overview.

CoreSolution Models

The FSM CoreSolution All Cap World 2S Model saw a change in the latest evaluation, with the Invesco S&P 500 Pure Value ETF RPV being sold from the model and replaced by the Invesco S&P 500 Pure Growth ETF RPG. The growth representative joins the Invesco S&P 500 Equal Weight ETF RSP in an equal-weighted fashion, leaving the portfolio at a substantial overweight toward large-cap growth. Technology is now the most overweight sector in the portfolio at just over 28%, followed by consumer cyclical at about 17% and healthcare at 15%.

Flexible Allocation Models

The FSM Vanguard 5S Model saw two changes in the most recent evaluation, with the Vanguard Small-Cap Index Fund NAESX and the Vanguard Tax-Managed Capital Appreciation Fund VTCLX each being sold from the portfolio. In their place, the model purchased the Vanguard Growth Index Fund VIGRX and the Vanguard US Growth Fund VWUSX. This leaves the fund at an overweight toward large-cap growth, a theme reflected across many of the most recent model changes. The most overweight sector is again technology at 31% with a high allocation also seen in consumer cyclicals at 20%, followed by financials and healthcare, which each make up about 10%, 20% total, of the portfolio.

Other Equity Focused Models

The FSM First Trust SelfDirect 5S Model saw 100% turnover in the latest evaluation, with five positions being sold and five new positions added. The model moved away from value, financials, and dividend achievers representatives. In their place, the model purchased representatives for growth, consumer cyclicals, technology, and even the First Trust Water ETF FIW. Similar to the other equity-focused models, this strategy is now overweight technology at 31% with high exposure seen in consumer cyclicals at almost 25% and industrials at almost 19% of the portfolio.

The FSM Schwab Macro Blend 5S Model saw two changes this week, with the portfolio removing the Schwab US Broad Market ETF SCHB and the Schwab US Small-Cap ETF SCHA. The model gained exposure toward the Schwab US Large-Cap Growth ETF SCHG and the Schwab US REIT ETF SCHH. Interestingly enough, this leaves the portfolio with an overweight position toward real estate at roughly 23% of the model, with high exposure also seen in technology (21%) and consumer cyclicals (16%).

Daily Option Ideas for August 5, 2021