Dynamic markets may favor a hybrid of active and passive investing

Low fees and strong market returns have made a compelling case for passive strategies as core building blocks in diversified U.S equity portfolios.

No wonder the four largest exchange‑traded funds (ETFs), each of which tracks the S&P 500 Index, last year garnered more than one‑third of the inflows to equity‑focused strategies.¹

Questions about the outlook for inflation, rapidly evolving government policies, and the next phase of the artificial intelligence (AI) revolution have increased market volatility and suggest that we could see greater dispersion in companies’ business fundamentals.

What options exist for clients who are concerned about overly relying on strength in the broader market to meet their long‑term investment objectives but don’t want to take too much active risk?

A hybrid alternative to S&P 500 and chill

When well designed and executed, an active‑enhanced index strategy² has the potential to add value in a variety of environments by seeking a market‑plus return with market‑like risk.

The key is thoughtfully combining the advantages of passive and active investing.

• Risk controls: Strict constraints on active weightings at the sector, industry, and company levels aim for a similar look and feel to the wider market. This broadly neutral portfolio should entail less exposure to extreme swings in style and sector leadership than purely active strategies. 
• Stock selection: Within these guardrails, overweighting companies where the risk/reward setup appears attractive and underweighting or avoiding businesses with less favorable prospects creates opportunities to generate market‑plus returns.

Approximating an index’s characteristics can sometimes constrain the magnitude of a portfolio’s potential outperformance in the short term. But these risk controls should also reduce the potential that it will lag the benchmark by a wide margin.

If stock selection manages to add relative value consistently, these incremental returns can add up over longer periods.

Focusing on fundamentals can add value

The potential advantages of active‑enhanced index strategies that rely on rigorous fundamental research may be more pronounced in times of uncertainty and shifting market conditions.

Stock selection and position sizing in strategies that track a capitalization‑weighted index tend to reflect where a company has been, as opposed to where it might be headed.

Putting experienced investment analysts in charge of stock selection in their area of expertise should result in a more dynamic portfolio that may be able to better capture how a company’s prospects and risk/reward profile might change over time.

"The potential advantages of active‑enhanced index strategies that rely on rigorous fundamental research may be more pronounced in times of uncertainty...."

Collaboration among analysts across regions, sectors, and asset classes can lead to a robust view of the wide‑reaching implications of rapidly evolving trends, such as deglobalization and the rise of AI, and the companies that appear best positioned to navigate these uncertainties.

Whether it’s a possible peak or trough in the market, a sector, or a stock, these insights into individual companies and industries can give analysts the courage of conviction to trim or add to a position when uncertainty is high.

And delegating this responsibility across a deep analyst pool results in a diversity of opinions and investment styles that may help to mitigate some of the biases and blind spots associated with a single‑manager strategy.

With this risk‑controlled and research‑driven approach, the potential for outperformance is spread across a diversity of sectors, industries, and individual companies—even when a handful of stocks are driving the index.

Research in motion

Fundamental research can help to add value when the differences in stock performance are especially high.

Here’s how three of our analysts are navigating the challenges of today while keeping an eye on potential longer‑term opportunities.

Balancing near-term caution with selective long-term optimism

Chris Graff
U.S. internet analyst

Seeking an edge: The mega‑cap consumer internet companies are often lumped together as their own asset class. However, they are unique businesses that require nuanced analysis to gauge their relative risk/reward profiles. Working closely with a deep team of global technology analysts, as well as portfolio managers who have also followed these companies for decades, yields spirited debates that can result in differentiated insights.

Less favorable: The maturity of the dominant consumer internet companies has made them more sensitive to economic weakness. For example, as we saw in 2022, spending on online advertising is relatively easy to turn off when concerns emerge about the health of the economy and the consumer. In terms of secular risks, the online search business is facing pressure from popular generative AI models. Caution and selectivity are warranted in the near term.

“In terms of secular risks, the online search business is facing pressure from popular generative AI models.”
Chris Graff, U.S. internet analyst

Attractive: Over the long term, the large consumer internet companies generally appear to be well positioned to benefit from the AI revolution, thanks to their massive user bases, troves of valuable data, and computing power. Online advertising has emerged as a leading use case for AI because it has helped to boost engagement and improve the effectiveness of marketing campaigns. Large providers of cloud services should also benefit as AI workloads increase. Still, the speed of innovation taking place with AI requires vigilance around potential disruption. Some companies may also have more leeway than others to trim costs without impairing their growth prospects.

What to watch: The AI landscape is evolving quickly. The ability to take a long view on which companies are best positioned to benefit sustainably from the rise of AI can provide the conviction to take advantage of any short‑term dislocations that might occur if the market mistakes temporary headwinds for something more durable.

Mindful of business fundamentals and valuations

Greg Locraft
Portfolio manager and insurance analyst

Seeking an edge: A long history of focusing on insurance stocks can yield a more textured view of what’s happening in the industry’s different segments and at individual companies. These insights can help to identify instances where business fundamentals appear set to improve, valuations look attractive, and management teams are likely to add value through smart capital deployment. They can also help in avoiding situations where the risk/reward balance seems less favorable on these three dimensions.

“...Ongoing pricing increases in personal lines…makes reasonably valued companies in this segment more attractive.”
Greg Locraft, Portfolio manager and insurance analyst

Attractive: Well‑run property and casualty (P&C) insurance carriers and brokers operate relatively defensive business models because their products are nondiscretionary purchases. They also tend to benefit from the end of the lower‑for‑longer rate environment as they can boost their investment income by rolling maturing bonds into higher‑yielding securities. Selectivity, however, is critical for investors. After seven years, the pricing upcycle for commercial lines (insurance for businesses) has shown signs of waning, so a focus on quality at an attractive valuation is more important. On the other hand, ongoing pricing increases in personal lines (insurance for consumers), led by home insurance, makes reasonably valued companies in this segment more attractive.

Less favorable: A highly selective approach to the life insurance segment is warranted due to the rising risk of an economic recession. Life insurance business models are more sensitive to fluctuations in equity and credit markets as well as interest rates.

What to watch: Along with valuation discipline, a deep understanding of each company’s business mix and any idiosyncratic drivers of upside potential or downside risk will be important in this unsettled environment.

Seeking durable growth and avoiding disruption

Ari Weisband
Portfolio manager and payments analyst

Seeking an edge: Analyzing private and publicly traded transaction‑processing companies of varying sizes and from various sectors is helpful to understanding how innovation is creating challenges for some companies and opportunities for others.

Attractive: Some established transaction processors offer the prospect of solid growth at a reasonable price, operate relatively resilient businesses, and, critically, are allocating capital in ways that can create value for shareholders.

“Traditional payroll processers appear vulnerable to pricing and market share pressure from cloud-based software solutions.”
Ari Weisband, Portfolio manager and payments analyst

Less favorable: Traditional payroll processers appear vulnerable to pricing and market share pressure from cloud‑based software solutions. Potential weakness in the labor market may also warrant caution and selectivity in this space. Within e‑commerce payments, growing competition from big tech and mobile checkout solutions could be a sustained headwind for certain incumbents.

What to watch: Macroeconomic uncertainty and market volatility could create favorable setups in companies that appear well positioned for the long term but could face near‑term headwinds because of their businesses’ cyclicality. Potential disruptors in payroll processing could be one area to watch.