So far this year, nine of the largest ten US listed active ETFs have lagged behind the S&P 500 trackers, even though their fees are between 7 and 10 times higher than the cheapest S&P 500 trackers. Vanguard’s VOO and iShares’ IVV have a TER of 0.03% while the biggest active ETFs charge between 0.20% and 0.30%.
The extra expenses can only explain a small part of the underperformance in the first half of 2024, since some of these funds have lagged the index by as much as 10%.
This should not really surprise anyone. For decades it has been notoriously difficult for active equity managers to outperform the S&P 500 index, since it selects the largest profitable listed companies from the most efficient capital market and the largest economy in the world, which is also the leader in many areas of technology and healthcare.
It 2024 it has been even more difficult than normal for active managers to outperform, because the largest index members have been driving most of the returns. If an active manager holds index level weights in the biggest stocks, they will often be accused of being a “closet tracker” or “enhanced tracker” and not doing their job as an active manager.
It is very difficult for an active manager to hold and maintain an overweight position in a stock like Nvidia, sometimes for regulatory reasons. In Europe many ETFs are UCITS and cannot hold more than 10% in a single stock. Even if they started 2024 with 10% in Nvidia, they would have had to be more or less constantly selling Nvidia to keep it under 10%. In practice, they will probably try and keep it comfortably below 10% since dealing with a “regulatory breach” every day or week is a nuisance that may have to be documented and reported. This creates extra stress for compliance staff who already have enough to worry about.
Regardless of regulations, even some ETFs branded as “concentrated” or “focused” will often have diversification guidelines across 20-30 stocks that still imply smaller weightings than the largest MAG7 weights in the S&P 500. Thirty equal weighted stocks will have positions of 3%, while the top four S&P 500 member are larger than 3%.
There are however some exceptions and in 2024 one ETF stands out. BlackRock US Equity Factor Rotation ETF (DYNF) is up 20%, beating the S&P 500 by 4%. This quantitative strategy uses economic, valuation and sentiment data to rotate around five factors: quality, value, size, low volatility, and momentum.
For instance, its last report on June 17, 2024 shows it is emphasising higher quality, stronger momentum, higher volatility, mega cap size, and high growth, while being neutral on value. Its top ten holdings: Microsoft, Nvidia, Apple, Amazon, Berkshire Hathaway, Visa, JP Morgan, Meta, Alphabet and Broadcom overlap with 8 of the top 10 S&P 500 stocks; the differences are Alphabet and Eli Lilly in the index but not DYNF’s top ten.
Some investors may therefore dismiss this product as a “closet tracker” but sometimes outperformance is about hitting singles and doubles rather than home runs, to borrow US baseball parlance. For instance, DYNF’s Microsoft position is about 1% larger than the index, and Microsoft is up 22% year to date. The extra 1% in Microsoft could have added a few basis points to DYNF versus the index, and lots of sensible small decisions can add up to outperformance over time. Many traditional discretionary managers might be frightened to own more Microsoft than the index, but a quantitative strategy has no qualms about doing so.
Still, the spoiler alert is that over five years, DYNF’s 80% return has still lagged the S&P 500’s 86%. The US is a well-functioning capital market but styles move in and out of fashion, and products such as DYNF may well be able to outperform for certain periods.
Active managers may still argue that you need to look at a generation of data to fairly compare active and passive investing. After the TMT / internet / dot com bubble burst in 2000, small and mid-caps and value stocks beat the giants and this helped active managers, including hedge fund managers, to have a multi-year period of outperformance.