Indexology^® Blog

Anyone familiar with our SPIVA Scorecards will recognize that most active managers fail most of the time. Anyone familiar with active managers will recognize that they can be quite creative in proposing both excuses and remedies for this historical record. One of their most persistent suggestions, in fact, is that active management simply isn’t active enough, leading some asset owners to search for more “exposure to concentrated active managers.”

This approach is misdirected for at least three reasons:

First, it assumes that the level of a manager’s optimism about a stock predicts its future performance. The argument for concentration necessarily implies both that stock selection skill exists, and that it is particularly acute at its extremes. Not only, e.g., must a manager be able to build a 50-stock portfolio that will outperform, he must also be able to identify which 10 stocks of the initial 50 are the best of the best. For concentrated portfolios to outperform, both assumptions—that skill exists, and that it is acute at the extremes—must be true simultaneously. There is no evidence that either of them is. If it exists at all, the requisite skill must be quite rare. If this were not so, active funds would not be facing a performance challenge in the first place.

Second, under reasonable assumptions, concentrating equity positions raises the probability of underperformance. One of the most consistent characteristics of global equity markets is that returns are positively skewed—when graphed, they have a long right tail, as shown in Exhibit 1. This is intrinsically logical, since a stock can only lose 100%, but has unlimited upside.

For the 20 years ending in 2022, the median return of S&P 500 members (during their index membership) was 93%, far below the average return (390%). Only 24% of the index’s constituents outperformed the average stock. In such a market, a manager’s success is dependent on his ownership of a relatively small number of strong performers. The more concentrated a portfolio is, the less likely it is to own the big winners.

Third, concentrated portfolios make it harder to distinguish between signal and noise. While some managers may be skillful, none are infallible. A manager who is skillful but not infallible will benefit from having more, rather than fewer, opportunities to display his skill. A useful analogy is to the house in a casino: on any given spin of the roulette wheel, the house has a small likelihood of winning; over thousands of spins, the house’s advantage is overwhelming.

Skillful managers sometimes underperform; unskillful managers sometimes outperform. The challenge for an asset owner is to distinguish genuine skill from good luck. The challenge for a manager with genuine skill is to demonstrate that skill to his clients. The challenge for a manager without genuine skill is to obscure his inadequacy. Concentrated portfolios make the first two tasks harder and the third easier.

Our new research paper shows that Israeli investors have a greater home bias than other nations: they have invested more heavily in domestic equities and allocated to the U.S. in lower proportions than their developed markets peers such as the U.K., Europe and Canada. With U.S. equities making up nearly 60% of the S&P Global BMI’s market capitalization, such allocations may be overlooking a sizeable portion of the global equity opportunity set. Adding some U.S. decor to a domestic Israeli equity allocation also historically provided higher return in both absolute and risk-adjusted terms, and could offer the potential for diversification.

U.S. Equities Have Outperformed Their Israeli Counterparts over Various Horizons

The S&P 500^®, S&P MidCap 400^® and S&P SmallCap 600^® outperformed the Israeli equity market—as represented by the TA-125—by 15%, 11% and 9%, respectively, in Q1 2023 (all in ILS and total return terms). Exhibit 1 shows that this phenomenon is not just a recent one: U.S. equities have outperformed their Israeli counterparts over short-, medium- and long-term horizons in both absolute and risk-adjusted terms. Similar results are observed for USD-denominated versions of the indices.

Looking at the correlation of U.S. equities with the TA-125 and blue-chip TA-35 in Exhibit 2 we can see that all of the S&P Composite 1500^®’s component indices had a correlation of less than 0.5 (based on monthly returns since Dec. 31, 1994). This suggests an opportunity for U.S. equities to act as a diversifier when incorporated into Israeli equity allocations.

Despite recent spikes in 3-year rolling correlation, compared to correlations over the last 28 years, U.S. and Israeli equities are not perfectly correlated (equal to 1), which means there is still opportunity for diversification. In recent times, that opportunity has increased, with U.S. and Israeli equities continuing to decouple from their 2020 coronavirus correlation highs.

The outperformance of U.S. equities, and their lower long-run correlations with Israeli equities since December 1994, has meant that adding U.S. equities to an Israeli equity allocation could have improved returns, with lower volatility. Exhibit 4a shows the annualized return and volatility figures for various hypothetical combinations of the S&P 500, S&P MidCap 400 and S&P SmallCap 600 with the TA-125, starting with a 100% Israeli allocation and moving in 10% increments to a 100% U.S. equity allocation. Each hypothetical portfolio rebalances back to the target weights at the end of each quarter.

In addition to the potential performance and diversification benefits, incorporating U.S. equities may help Israeli investors to alleviate domestic sector biases. Compared to the S&P 500, Israeli equity indices like the TA-125 and TA-35 are heavily overweight Financials and Real Estate, while underweighting Information Technology by 11%, as shown in Exhibit 4b. The S&P 500’s largest constituents include some of the world’s most well-known “big tech” companies, such as Apple and Microsoft.

While U.S. equities are not the only way to seek diversification, investors may wish to evaluate their U.S. equity exposure in order to avoid overlooking a sizeable portion of the global opportunity set. A simple flourish of U.S. equities may not be enough to decorate a home, and so one may want to consider a real twist to measure the full potential of U.S. equities across capitalization ranges, especially as smaller U.S. equity segments are as large as other countries’ stock markets.

The inaugural S&P Indices versus Active (SPIVA^®) U.S. Scorecard was published in 2002, and has since been extended to Australia, Canada, Europe, India, Japan, Latin America, South Africa and the Middle East & North Africa (MENA), allowing investors to experience the active versus passive debate on a global scale.

The SPIVA Japan Scorecard measures the performance of actively managed funds domiciled in Japan against their respective S&P DJI comparison benchmarks over various time horizons, covering large-, mid- and small-cap, as well as international and global equity funds.

According to the recently published SPIVA Japan Year-End 2022 Scorecard, 70% of All Japanese Equity funds underperformed the broad-based S&P Japan 500 over the full-year 2022, and more than half of equity funds underperformed their benchmarks in every reported category, except for International Equity funds, which had an underperformance rate of 42% (see Exhibit 1).

Several aspects of the market environment in 2022 stood out as potentially indicative of a favorable environment for active managers in Japanese equities over the period. For example, the largest companies (as represented by the S&P/TOPIX 150) had lower returns than small- and mid-sized Japanese companies (as represented by the S&P Japan MidSmallCap; see Exhibit 2). This potentially created a tailwind for active managers, as funds are typically less likely to own all the largest stocks at market weight.

Second, opportunities for outperformance through stock selection were plenty in 2022. At the benchmark level, dispersion is the measure of the degree to which securities differ—above or below—the average performance.¹ As illustrated in Exhibit 3, the average monthly annualized dispersion in the securities of the scorecard comparison indices was higher in 2022 than was typical over the past 10 years.

Due to the costs associated with running any portfolio, an actively managed fund may still underperform even if it picks outperforming securities. For an active manager, the key is to find not just securities that outperform, but those that outperform materially. At times when most securities perform similarly, differentiation is surely harder to find. Then, there are other times when the difference between winners and losers is larger.

Taken all together, the data in the SPIVA Japan Year-End 2022 Scorecard suggest that among the active funds offered in Japan, International Equity managers were relatively more successful in turning opportunities into positive outcomes. However, active funds in all the other fund categories struggled to take advantage of the abundance of opportunity presented in 2022’s market environment.

¹ For example, see Edwards, Tim and Craig J. Lazzara, “Dispersion: Measuring Market Opportunity,” S&P Dow Jones Indices, 2014.

How does indexing work for large-cap equities? S&P DJI’s Hamish Preston and State Street Global Advisor’s Michael Arone take a closer look at lessons from 20 years of SPIVA, including fee savings, outperformance, and what the latest GICS® changes mean for sectors and industries moving forward.

The U.S. equity market is by far the largest in the world, representing 57.7% of the global market capitalization, and it is nearly nine times the size of the Japanese equity market (see Exhibit 1). Hence, Japanese investors may wish to consider U.S. equities in order to not overlook a significant portion of the global opportunity set.

The S&P 1500™ is designed to measure the performance of the U.S. equity market and its construction helps it avoid less liquid, low priced and lower quality stocks. The index combines the S&P 500^®, S&P MidCap 400^® and S&P SmallCap 600^® and captures over 90% of the U.S. equity market capitalization. Although smaller U.S. equity segments may seem less relevant to international investors, the breadth and depth of the U.S. equity market means that mid- and small-cap U.S. equities represent a significant portion of the global market and are larger than some regional markets.

The U.S. equity market has distinct sector exposures, so one potential benefit of incorporating U.S. equities is that they can help to alleviate domestic sector biases. For example, Exhibit 2 shows the GICS^® sector weights of the Japanese equity market—as represented by the S&P Japan 500—and its relative sector weights versus the S&P 1500. Adding U.S. equities can help redistribute sector weights toward the I.T., Health Care and Energy sectors, while also decreasing the concentration to Industrials, Consumer Discretionary and other sectors.

The historical performance of U.S. equities may offer another potential reason for Japanese investors to consider U.S. equities. Exhibit 3 shows that the U.S. equity indices have outperformed the Japanese equity indices since 1994. The S&P 1500 slightly outperformed the S&P 500 due to its exposure to mid and small caps.

Exhibit 4 depicts the long-term risk/return tradeoff for several hypothetical portfolios combining the S&P Japan 500 and S&P 1500 in JPY. The chart shows that increasing allocation to the S&P 1500 provided better performance than purely local strategies, historically.

From its representation of a significant portion of the global opportunity set, to potential sector diversification benefits and historical performance improvements, U.S. equities may be worth consideration for Japanese market participants.