Active Funds Gain An Edge In 2024’s First Half

According to Morningstar, the total industry-wide amount of money invested in passive funds exceeded that of active funds for the first time as of this year. Fidelity investors appear to be even bigger fans of indexing, with well over half of total mutual fund assets invested in passive funds.

It’s not hard to see how we got to this point. Passive investing always had a compelling story, and the financial media made sure that we all read it many times over during the last 15 years. It goes like this: it isn’t necessary to pay for a manager to pick stocks when an index provider can tell you what to buy for a fraction of the cost. It appeared to be the right message at the right time. Corporate consolidation activities that followed the 2008 Financial Crisis made large-cap firms more profitable, allowing stock buybacks to serve as a great equalizer. By helping slow-growth firms post EPS numbers that were on par with faster-growing firms, everyone became a winner in the large-cap space, making it easy to go passive. Just buy the S&P 500, and let the Standard & Poor’s Index Committee figure out the portfolio. Imagine frozen dinners that taste as good as any restaurant meal. You wouldn’t need to pay for a chef.

While going passive worked great for investing in U.S. large-caps over the last 15 years, it was not a universal formula for success. In markets where profit margins were not as high (limiting the cash flow available to conduct stock buybacks), or where consolidation efforts were heavily restricted by regulations and/or labor laws, results were mixed. On the foreign front, where well managed technology firms are few and far between, active funds routinely outperformed their passive benchmarks, with the money invested in passive strategies reaching only a quarter of the total amount invested. The U.S. bond market (where bond rating agencies are slow to recognize change) is another place where passive investors have not always won the race. Ignoring debt management skills and indexing to the biggest issues works okay for government securities. But on the corporate side (where bankruptcy risk is a factor), active bond managers doing in-depth credit analysis often have a significant edge over the market, which doesn’t have enough collective wisdom or public data to price bond issues efficiently.

But now we are seeing some early signs that even the S&P 500’s unshakable performance lead may be vulnerable. The AI revolution is magnifying the differences among large-cap stocks, creating bigger winners and bigger losers based on the expected benefits the new technology will bring to the table. For a savvy active manager, this is fertile ground after a long period of drought. Fidelity is already claiming victory in the large-cap growth segment, having bet heavily that corporate spending on NVIDIA chips would continue to lift the stock this year. Just getting that one thing right has provided a significant first-half performance benefit.

But this 2024 upset win for active funds goes beyond NVIDIA. Throughout the mid-cap, small cap and foreign stock categories, there are many examples where Fidelity’s active funds showed improved performance relative to their passive benchmarks.

Even in the sector universe, where Fidelity’s Select lineup has been struggling with unusually weak small-stock performance, the percentage of funds beating their passive benchmarks has surged, as shown in the chart above (our Select Model results for the first half were strong relative to the average Select, but we still finished a bit shy of the S&P 500).

Time will tell if we are witnessing a renaissance for active funds, but it seems a likely scenario. Productivity and earnings benefits await the early AI movers in nearly every market segment, and active funds backed by solid research have potential to know who has the most to gain.

Fidelity, with its long-running expertise in evaluating technology firms, especially chipmakers, may have a catbird seat in the race to identify other potential winners that could follow NVIDIA. Second Quarter Review
In the second quarter, the expected timeframe for getting inflation under control grew longer, with the Fed ultimately resetting expectations (in June) for just a single rate cut between now and the end of the year. The reality check weighed on smaller stocks and value-oriented large caps, but large-cap growth stocks continued to log gains -- primarily on continuing optimism that AI will elevate earnings growth, especially in the technology and communications services groups. The S&P 500 gained 4.3% for the three-month period, bringing its year-to-date gain to 15.3%. The Russell 2000, in contrast, declined 3.3% bringing its 2024 total return to 1.7%. The bond market suffered during April as rate-cut expectations went out the window, but improving inflation news allowed for recovery in May and June, allowing most bond funds to finish the quarter in the black. The Bloomberg Barclays US Aggregate Bond Index finished just ahead of breakeven (0.1% gain) for the quarter, ending with a year-to-date decline of 0.7%. Our stock-oriented portfolios trailed the S&P 500, though not by much. The continuing strength of large-cap growth stocks prompted us to moderate our plans for rotating into value stocks and rebalancing in favor of bonds in our blended portfolios, though we did bring our volatility scores more in line with their targets. On the bond side, overweighting corporate debt and focusing on issues with shorter maturities continued to work in our favor, allowing us to stay slightly ahead of the Bloomberg Barclays index for the quarter. Outlook
Lacking any big negative events on the inflation front, the Fed seems on track for a September rate cut. But don’t expect any big reaction from the markets, as it’s widely expected. What matters more is what happens after that. Will the Federal Funds rate drop below 4% in 2025, or remain closer to 5% for most of next year? The former scenario might allow smaller stocks and other economically-sensitive groups to break out of the doldrums, where as the latter will probably not.

Meanwhile, earnings forecasts remain reasonably upbeat, expectations for AI technology remain high, stock buyback activity is recovering, and investors who have been sitting on excess levels of cash are beginning to put some of it to work. Even without much help from the Fed, the stock market may be able to hold its own.

But don’t assume it will be a smooth ride. Underneath the surface of the relatively calm broad indexes is a lot of turmoil at the individual stock level. While AI technology holds potential for companies to grow faster, it means that they can go broke faster too. In other words, bigger winners and bigger losers. Those who enjoy excitement during earnings season probably have a lot to look forward too. As do active managers. As I alluded to earlier, the reward for being right about a stock (or an industry trend) has grown, in some cases by leaps and bounds. Fidelity’s active managers, who are backed by extensive fundamental research, seem likely to benefit from this shift.

As for our portfolios, we are considering an additional reduction in our mid-cap stock exposure. And on the bond side, we are starting to look at how we might position for a more accommodating Fed while keeping bond risk at or below present levels.

Sincerely,

Jack Bowers
President & Chief Investment Officer