Allocators are considering throwing in the towel on large-cap active equity managers — but GMO says that doing so may be ill-advised.
In the decade ending in 2023, 90.2 percent of large-cap blend investment managers underperformed the S&P 500, according to Morningstar. So why wouldn’t asset owners want to drop these managers from their portfolio?
In its first quarterly letter of the year, GMO examined the causes of this underperformance (hint: Blame the Magnificent Seven) and made the case for staying in the game.
Historically, the largest stocks don’t outperform the S&P 500. Data cited by GMO shows that from between 1957 through 2023, nine of the top ten stocks have underperformed on average on a relative return basis.
However, the Magnificent Seven — Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla — have been primary drivers of equity market returns over the past year. Since 2014, they outperformed the S&P 500 every year except in 2022. In 2023, the outperformance was to the tune of 60 percent.
“When the very largest stocks are the best performing ones, it is an extremely difficult environment for active managers to keep up with, let alone outperform,” according to GMO.
This outperformance, however, has led to these stocks being significantly overweighted in the S&P 500 index. So why don’t active managers just mirror the index and reap the rewards?
Well, for one, they believe that the market is ultimately inefficient. And, as GMO puts it, “to outperform an index, it is necessary to look different from it.” And in a year — or years — where the top seven stocks dominate the market, it’s near impossible to outperform.
But the tides could turn. GMO points out that these stocks are expensive, with a price to earnings ratio of 37x, as compared to the overall market’s 25x ratio. Meanwhile, they share common risks, according to the firm.
They all rely on semiconductors, and most are invested in artificial intelligence. Of the seven, four use Foxconn, a Taiwanese company, to supply parts. According to GMO, these companies’ average revenue exposure to China and Taiwan is 20 percent. Macro concerns about a potential conflict between China and Taiwan represent a real threat to valuations.
“Investors who are averse to the 4 percent combined weight of China and Taiwan in MSCI ACWI should be mindful of the 17 percent combined weight of the U.S. superstars in that same index,” according to GMO.
According to the firm, sticking to an active manager can help an allocator diversify away from these risks. Only time will tell if that’s worth it.
