One simple choice can help your active stock investing

You may have heard this sales pitch before: “Now is the time for active management.” 

We don’t typically go all active or all passive in any given environment; both have benefits. Passive vehicles are generally lower cost, transparent and predictable relative to the market or index, but they don’t offer a chance to generate excess returns (“alpha”). Active strategies (when managers select stocks, seeking to beat the relevant benchmark index) give you that chance, but generally are higher cost and less likely to track an index.

That makes the decision on where to use active paramount.

The last 5 years show active managers have had greater success in certain equity categories: Small cap and some international markets. The majority of actively managed U.S. small cap and more than half of Asia ex Japan equity funds—70% and 55%, respectively—outperformed their benchmarks over the past five years, net of fees; so did the median manager in each category.

So considering to go active in small cap and some international markets in your portfolio may make sense.

Those strong results for small cap and some international managers stand out from the other six of eight equity categories we analyzed, where median managers underperformed their respective benchmarks. In U.S. large cap core, only 17% of managers outperformed their benchmarks.¹ To be sure, the data changes over different five-year periods. 

We believe it’s not a matter of finding the right time for active management. The key is where to consider using it in your porfolio. (And bear in mind, of course, that the top active managers often beat the odds by substantial margins—this analysis is of all active managers, not the best.)

Three factors can help improve active’s odds

While many variables can influence an active manager’s performance, we have identified three main factors that we believe explain why small cap and international active equity managers can be better at beating their market indexes. These markets generally have:

• Relatively low levels of analyst coverage

When fewer research analysts cover a company, it’s likely that estimates of the key metrics used to value a stock (things such as future revenues and earnings) can be less precise and/or vary widely. 

That holds true, for example, for stocks in the small cap Russell 2000 Index. Analyst earnings expectations for stocks in the index differ widely: by a standard deviation (a measure of dispersion) of 12.2%, compared to 4.4% dispersion for their large cap (S&P 500) earnings estimates.

Active managers with strong research capabilities can gain an information advantage in less-covered equities, lifting their chances of picking the better stocks. 

• High return dispersion 

Higher dispersion means the best-performing stocks do a lot better than the worst-performing stocks. Active managers can generate higher returns if they make the right call. Put another way: If they do, you can win big and vice versa.

For example, active managers have had an edge over the last 20 years in emerging market (EM) equities. On average, looking at the MSCI Emerging Markets Index, the difference between the best-performing country’s equities and the worst-performing country’s equities in the MSCI Emerging Markets Index was 99%.³ (Contrast that with S&P 500 stocks: the difference between equities in industry sectors with the highest returns and those with the lowest returns since 2003 was 42%).

• Low index concentration 

A highly concetrated market is one in which a few stocks with very large market capitalizations dominate (think Apple, Microsoft, Alphabet, Amazon in the S&P 500). Concentrated markets are challenging places for active strategies because managers must dedicate a lot of capital to the top positions just to be neutral vs their benchmarks.

For example, to be neutrally positioned vs, the S&P 500, a U.S. large cap strategy must put 32% of the portfolio in the top 10 stocks.

In contrast, the 10 stocks in the small cap Russell 2000 Index with the largest weight make up about 3% of the index. This lower benchmark concentration means active managers have more opportunities to find outperformers—and can take meaningful positions in them.

Consider going active in these markets

Currently, the areas of the equity market with low analyst coverage, high dispersion of returns and low index concentration are U.S. small cap, European and emerging market equities. These equity categories also had the highest percentage of active managers outperforming in our analysis.

Extra way to earn more

We encourage clients to consider other strategies, too. One is tax-loss harvesting, which is designed to generate “tax-alpha.” It can be used in both active and passive portfolios.

Put simply, tax-loss harvesting is the timely selling of securities at a loss, to offset investment gains elsewhere in your portfolio and on your balance sheet.

Instead of trying to outperform an index, a tax-loss harvesting strategy attempts to replicate an index’s performance, while actively selling individual securities when they fall in value. This allows you to capture tax losses while maintaining your exposure to the market.

You may be able to lower your tax bill at the end of the year by using the harvested losses to offset capital gains realized elsewhere on your balance sheet. A tax-loss harvesting strategy may also allow you to rely less on a manager’s stock-picking ability in areas where that is challenging and to use a market’s natural volatility to potentially generate extra value over time.

We’re here to help

We are here to help you make informed investment decisions that keep you on track for your wealth plan. Whether it’s reviewing your existing investment portfolio or seeking new investment opportunities, we can help you decide if an active or passive strategy is right for you. Contact your J.P. Morgan Team to learn more.

¹Source: J.P. Morgan Private Bank and Morningstar as of September 30th, 2023. Performance is net of underlying fund expense ratio.

²Source: Bloomberg Finance L.P. as of August 14, 2023.

³Source: Bloomberg Finance L.P. for 20 calendar years ended December 31, 2022. Based on the MSCI Emerging Markets Index.

The Russell 2000 Index is a small-cap stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index. It was started by the Frank Russell Company in 1984. The index is maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group.

The S&P 500 Index is an unmanaged broad-based index that is used as representation of the U.S. stock market. It includes 500 widely held common stocks. Total return figures reflect the reinvestment of dividends. “S&P500” is a trademark of Standard and Poor’s Corporation.

The MSCI Emerging Markets Index is an index that captures large and mid-cap representation across 24 Emerging Markets (EM) countries.