Most actively managed U.S. mutual funds focused on large-cap stocks failed to beat their Russell benchmarks last year as equities surged, but a broadening rally may give them a stronger chance of success in 2024, according to BofA Global Research.
Just 38% of active large-cap funds outperformed their Russell benchmark in 2023, “roughly in line with the historical average,” BofA strategists said in a note this month. They said that “narrow market breadth created a challenging backdrop for active funds in 2023.”
The U.S. stock market climbed last year as a small group of companies with massive market values helped drive big gains for large-cap indexes such as the Russell 1000
RUI
or S&P 500
SPX.
Some investors are willing to pay up for active managers with the hope they will outperform simple indexes tracked by passive, low-cost mutual funds or exchange-traded funds.
“I do think that we’ll continue to see a broadening out” in the number of companies participating in the stock market’s rise, said Kevin Gordon, senior investment strategist at Charles Schwab, in a phone interview. “We’ve already seen that in the past couple months.”
Both the iShares Russell 1000 ETF
IWB
and Vanguard Russell 1000 ETF
VONE,
exchange-traded funds that track the index, gained 26.4% last year on a total return basis, according to FactSet data. The S&P 500, a popular market-capitalization weighted gauge of U.S. large-cap stocks, similarly saw a total return of slightly more than 26% last year.
As for cost, the iShares fund has an expense ratio of 0.15%, while Vanguard’s ETF’s expense ratio is 0.08%. The iShares Core S&P 500 ETF
IVV
and Vanguard S&P 500 ETF
VOO
are even cheaper, each with an expense ratio of 0.03%.
Seven megacap companies known as Big Tech stocks, or the Magnificent Seven, propelled the S&P 500’s gains in 2023.
Fifty-four percent of large-cap active managers beat their S&P 500 benchmarks last year, compared with a long-term average of 41%, the BofA note on U.S. mutual fund performance shows.
‘Not out of the woods’
Rich Weiss, chief investment officer of multi-asset strategies at American Century Investments, said in a phone interview that he’s not excited about equities this year but sees relative value in real estate investment trusts, or REITs, as well as small-cap stocks.
“If you’re looking for value within the risky equity market, these are two areas that are the most promising, at least the way we see it,” said Weiss. That’s after being “beaten up mercilessly” in the last couple of years, he said.
Managers of active U.S. mutual funds targeting small-cap stocks “struggled in 2023, with only 36% outperforming” their Russell 2000 benchmarks, according to the BofA report. That’s “much lower than the last few years,” including a hit rate of 72% in 2022, the BofA strategists said. Their research found that 2023 was only the third year since 2015 that small-cap funds had a lower “hit rate” than large-cap funds.
Stocks broadly tumbled in 2022 as the Federal Reserve battled surging inflation with aggressive interest rate hikes. In 2023’s rebound, the small-cap-focused Russell 2000 index gained almost 17% on a total return basis but lagged far behind the Russell 1000 and S&P 500, FactSet data show.
Broader participation among sectors and companies in stock-market gains in 2024 would likely benefit active management, but so would a more problematic economy compared to passive investing, according to Weiss.
In his view, the U.S. stock market still faces a potential “hard landing” as the Fed continues its “balancing act between inflation and economic growth.” Weiss said he worries that subsiding inflation is not yet under control and that potential rate cuts this year by the Fed may wind up being the result of a recession. “We’re just not out of the woods,” he said.
Rather than making bets on various sectors of the stock market, Charles Schwab’s Gordon said he favors investing based on characteristics such as strong free cash flow or high interest-coverage ratios.
“If we truly are in a newer era of higher rates relative to where we were post-financial crisis up until the pandemic,” said Gordon, “you want to be looking for companies that don’t buckle under higher real interest rates.”
Within the universe of U.S. small-cap stocks, the S&P Small Cap 600 index
SML
has “more of a quality filter” than the Russell 2000
RUT,
he said.
Meanwhile, the U.S. stock market stumbled to start 2024. The S&P 500 is down 1.5% this year through Jan. 5 on a total return basis, while the Russell 1000 shed 1.6% over the same period and the Russell 2000 dropped 3.7%, according to FactSet data.
After the U.S. stock market’s climb in 2023, “if you’re an investor thinking you’ve missed a good chunk of the rally, for many parts of the market, you haven’t,” said Gordon.
“Less than 30% of stocks outperformed the S&P 500, the lowest annual breadth in our data history since 1987,” according to the BofA strategists. But breadth recently began to improve, “with 60% of stocks outperforming since November,” they said in their note.
“If the rally continues to broaden, active funds will have greater odds of selecting winners in 2024,” the BofA strategists wrote. “We expect more idiosyncratic opportunities next year.”
