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Investment Strategy

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.

Over the last 5 years active managers’ returns are better in small cap and some international market
Percentage of active funds in select equity categories that outperformed their benchmark indices (September 2018 – September 2023)
Percentage of active funds in select equity categories that outperformed their benchmark indices (March 2018 – March 2023)
Past performance is not indicative of future results. Source: Morningstar, J.P. Morgan Private Bank; data as of September 30th 2023. Performance is net of underlying fund expense ratio. Study covered the Morningstar EEA Open Ended Peer Groups and categories selected are the 8 largest by AUM on our platform.

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.

U.S. small cap, European and emerging market equities offer more potential for active managers to outperform
the bar chart shows industry 5 year performance for: US large cap core, growth, & value, US mid-cap, US small cap, EAFE, Europe, Global, and emerging market asset classes; Only in 2 of the 9 asset classes the median manager outperformed.
Past performance is not indicative of future results. Source: Morningstar, J.P. Morgan Private Bank, data as of March 31, 2023. Performance is net of underlying fund expense ratio. Study covered more than 3,000 active mutual funds and ETFs.

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.

The decision to use an actively managed strategy for your equities may not be about when but where. Here’s how we suggest you think about it.

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Important Information

Tax loss harvesting may not be appropriate for everyone.  If you do not expect to realize net capital gains this year, have net capital loss carryforwards, are concerned about deviation from your model investment portfolio, and/or are subject to low income tax rates or invest through a tax-deferred account, tax loss harvesting may not be optimal for your account. You should discuss these matters with your investment and tax advisors.

Past performance is no guarantee of future results. It is not possible to invest directly in an index.

JPMorgan Chase & Co., its affiliates, and employees do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal and accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transaction.

All third-party companies referenced are shown for illustrative purposes only, and are not intended as a recommendation or endorsement by J.P. Morgan in this context.

EQUITIES

The price of equity securities may rise or fall due to the changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general may decline over short or extended periods of time.

DIVERSIFICATION

Diversification and asset allocation does not ensure a profit or protect against loss.

SMALL CAP

Small capitalization companies typically carry more risk than well-established "blue-chip" companies since smaller companies can carry a higher degree of market volatility than most large cap and/or blue-chip companies.

EMERGING MARKETS

Investments in emerging markets may not be suitable for all investors. Emerging markets involve a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Some overseas markets may not be as politically and economically stable as the United States and other nations. Investments in emerging markets can be more volatile.

CONCENTRATED EQUITIES

Investors should be cautious when holding a highly concentrated stock position, which is typically defined as any individual holding that constitutes more than 30% of overall investment holdings. Tax consequences, including the avoidance of capital gains through selling, do not eliminate the risks of overexposure to a particular company or business sector.

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Any views, strategies or products discussed in this material may not be appropriate for all individuals and are subject to risks. Investors may get back less than they invested, and past performance is not a reliable indicator of future results. Asset allocation/diversification does not guarantee a profit or protect against loss. Nothing in this material should be relied upon in isolation for the purpose of making an investment decision. You are urged to consider carefully whether the services, products, asset classes (e.g. equities, fixed income, alternative investments, commodities, etc.) or strategies discussed are suitable to your needs. You must also consider the objectives, risks, charges, and expenses associated with an investment service, product or strategy prior to making an investment decision. For this and more complete information, including discussion of your goals/situation, contact your J.P. Morgan team.

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