When to Consider Active Management for US Large Cap Stocks

US equities are in the midst of a solid bull run as the market has steadily melted higher for the past year and a half. What began as a surge led by the Magnificent Seven stocks has now broadened out to the rest of the market. Yet with US large-cap stocks continuing to dominate, you might ask: why not just invest in a passive index fund and call it a day?

Most passive strategies are designed to take market weights as gospel, giving the most weight to recent top performers. While that approach may thrive in a momentum-driven market, it also raises two key risks. First, this can lead to unexpected or undesired overweight positions in certain companies, sectors, or themes. Second, the market often struggles to gauge the prospects of future trends, especially disruptive ones.

So when it comes to investing in large-cap stocks, the answer might not come down to a choice between active and passive management, but to combining the strengths of both. This hybrid approach can harness some market efficiency while enabling more deliberate management of the market’s risks.

Made from Concentrate

To truly understand the market’s evolving landscape for US large-cap stocks, it’s essential to look beyond the surface and examine the shifting dynamics within. History shows that today’s top stocks are rarely tomorrow’s winners. Over time, the market’s gradual upward march often masks the transitions unfolding beneath the surface. Mature businesses reach their relative peak and, though their share prices may still climb, they ultimately give way to newer, more innovative companies aligned with current trends.

Look at the top 10 stocks in the S&P 500 in 1990, 2000, 2010, and 2020. Each decade, around half of those stocks were displaced by others (Display). As the tides of creative destruction played out in the real world, the markets reflected those changes. What does that mean for the outsized weights of today’s top 10? Their eventual rotation out of the top could have a particularly pronounced impact on investors in the broad market index.

That’s where active management of a large-cap investment strategy comes in. The underlying dynamics of an index can cause active performance to periodically boost or detract from relative returns. Often, a period of sharp underperformance due to a certain theme is followed by a stretch of substantial outperformance as that theme fades or implodes. Think of market concentration as a double-edged sword. On one hand, if the market leaders remain relatively undervalued, that’s an opening for passive investors. But, if they’re overvalued versus fundamentals, they introduce unmanaged risk.

In 2023, the major market trend was the Magnificent Seven’s dominance. By the end of the year, they accounted for two-thirds of the S&P 500’s returns for the year and totaled 28% of the index.

Yet even inside the Magnificent Seven, there was room to add value. Skilled active managers investing in large-cap stocks could discern which stocks in the group were fairly priced based on their future prospects or even offered compelling value—and which ones were overhyped beyond their intrinsic worth. So far this year, that skill has paid off handsomely. The correlation among the seven stocks has fallen and the dispersion between their returns has widened, creating fertile ground for astute active investors (Display). Those who foresaw this shift have not only outperformed these market leaders but outshined the broader market too.

The Trend Is Your Friend, If You Can See How It Bends

Active management can also add significant value as a large-cap investing strategy by better anticipating future trends—in either direction. The market has long been prone to hype cycles, driving stock prices to unjustified heights. And history is littered with examples of irrational exuberance, from the South Sea bubble of the 18th century to the Nifty Fifty and the dot-com bubbles of the 20th century, all leading to eventual losses for speculators. In the 21st century, we’ve already seen two crypto bubbles, and a third may be inflating today.

Yet many active managers who find themselves struggling as a bubble inflates are ultimately vindicated once it bursts in the long run. By identifying and avoiding a growing risk, savvy active managers can successfully deliver not only attractive risk-adjusted returns, but also strong absolute returns for those investing in large-cap stocks. What’s more, while the market may correctly identify the potential of an overall trend, it frequently misjudges the winners and losers within that theme.

In the early stages of groundbreaking technological advancements, a critical issue often goes unnoticed. Remember the dot-com bubble? Imagine if we told you that the market actually underestimated the internet’s significance. Take 1996, for example: experts predicted 152 million internet users by the year 2000. The reality? A staggering 361 million users—more than double the forecast. That same pattern has been seen with the uptake of other technologies, including the PC, mobile internet, and cloud computing (Display). Faster-than-expected adoption, combined with a longer runway, can fuel massive upside and long-run returns.

For instance, most people probably thought they had a decent handle on the credit card industry in 2006. Yet somehow, over the past 20 years, the monumental shift from cash to card payments has propelled Mastercard’s stock to soar 100-fold. And Visa, which went public in 2007, has seen its stock skyrocket nearly 200-fold since then.

The hottest topic in today’s markets is undoubtedly AI, and those investing in large-cap stocks have many ways to surf that wave. At the forefront are companies like Nvidia, which dominates the production of AI chips, and ASML, which manufactures the essential equipment for chip-making. Further down the curve, you’ll find cloud operators, application developers, the power companies fueling this energy-intensive industry, or even cable makers supplying the wiring for modern infrastructure.

And active management, with its inherent agility, holds a distinct advantage as thematic stories unfold among US large-cap stocks. Its nimbleness allows active managers to reposition based on new information or shifts in the theme, even as it occurs over a decade or more.

Don’t Stop Believing

Mitigating risks that become too high when left unmanaged and enhancing returns over time are two key ways astute active management can add value as a large-cap investment strategy.

Depending how benchmark-sensitive you are—and how much underperformance you can tolerate and for how long—you may seek out US large cap equity exposure in a number of ways.

At one end of the spectrum, for the most benchmark-sensitive investors who can’t tolerate any deviation from the index’s return, a fully passive solution is ideal. At the other end, investors who believe their active managers can better assess risk and reward than the market may prefer a fully active solution.

Those in the middle may consider diversifying. This could involve having part of your portfolio managed passively, in case the market remains narrow, while the rest is managed actively, to capitalize on potential opportunities if the regime shifts away from recent winners.

There’s a solution for everyone investing in large-cap stocks. If you’re trying to find the right one for you, a conversation with your wealth advisor may be in order.