Opinion

John Authers

Active Fund Managers Beat Michael

Jordan, For Once
Was 2022 a single rebound, or the beginning of a dynasty to
snap the losing streak against passive index investing?

The game would need to change a lot more to bet against Michael Jordan at the free-throw line. Photographer:
Tom Berg/WireImage/Getty

By John Authers
January 23, 2023 at 1:02 PM GMT+8

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2022 was a great year for active fund managers, at least when it came to confronting the passive
aggression from the growing ranks of index-following funds. Most of them, according to various
Wall Street researchers, actually beat their benchmarks over the 12 months. Even if they didn’t
make money, they at least managed to limit losses for their clients, after a decade in which most
active managers, year after year, had failed to beat their index. But does that matter? To answer
that question, let’s look at the chances of beating Michael Jordan in a free-throw contest. (For non-
basketball aficionados: Jordan is widely regarded as the greatest player ever, and a free throw is a
little like a penalty in soccer, in which a player stands on the designated spot and makes an
uncontested attempt to put the ball through the basket.)

Craig Lazzara of S&P Global offers the following allegory from the Indexology blog. He is no great
athlete, but he has to take on Jordan in a free-throw contest. His chances of making each shot are
(generously) 20%; Jordan’s, over the course of his career, were 83.5%. It’s therefore obvious that
you should bet on Jordan to win. He is unquestionably the more skilled of the two. But the shorter
the contest, the better the chance that Craig will somehow eke out a victory. After one shot each,
there is a one-in-three chance that he will not be behind, and a 3.3% chance he’s ahead:

His chances of victory wane from there. But in one observation, there’s a really decent chance that
an unathletic finance guy can hold his own against the greatest basketball player of all time.
Lazzara defines the moral of the story as follows:

The low-skill player looks better when there are fewer trials and luck can play a bigger role. Over
short periods of time, luck can dominate skill. On the other hand, the high-skill player benefits from
more trials, since his higher level of skill is likely to overcome any bad luck that may come his way.

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Lazzara is a trenchant advocate of indexed investing, for logic which is by now familiar to all. The
costs of indexing are much lower than for active managers. The chance that an active manager can
beat the index once those fees are taken into account are therefore less than 50/50. With the stock
market effectively dominated these days by institutional funds (which wasn’t always the case), the
business of fund management is growing increasingly similar to a zero-sum game; those beating the
index will be balanced by those who lose to it. These arguments have led the growth of passive
investing over the last three decades. So, was 2022 a genuinely important development showing
that active management is about to deliver the goods again — or is it the fund management
equivalent of Craig Lazzara making his free throw while Michael Jordan misses his? 

It’s beyond doubt that active fund managers really did beat their passive counterparts last year.
Data from Strategas Securities show that in one universe of large cap core managers, 62% beat the
S&P 500 to notch the highest percentage since 2005, when 66% beat the index. More to the point,
this was the first year that a majority of active managers beat the S&P since 2009. Last year brought
an end to more than a decade of persistent underperformance by active managers: 

This could be an example of being fooled by randomness, but the length of the underperforming
streak for active managers looks improbably sustained on the face of it. Can we be sure that there
was no clear underlying reason for it? If there is, then perhaps it’s reasonable to hope that active
managers can do better for a while.

As is turns out, there is a clear explanation. It was the FANGs’ fault. “The fact that many managers
simply do not hold the top five companies at the same weight as the index has been accretive to
portfolio performance,” analysts at Strategas including Ryan Grabinski wrote in a note earlier this
month. As 2022 started, the S&P 500 was dominated to an unprecedented extent by its biggest five
stocks. The following chart from Strategas suggests that this was something close to a unique
opportunity:

It’s very difficult for any active manager to justify being overweight in five stocks that already make
up more than 20% of the index. They have therefore tended to be underweight in the FANGs
relative to the S&P throughout the rise of the internet platforms (the acronym originally stood for
Facebook, Amazon.com, Netflix and Google, and has persisted through name changes and the
addition of the likes of Apple, Microsoft and Tesla). 

Now, was this a one-time opportunity to profit from the correction of an anomaly, or the beginning
of a trend that can persist? The declining market in 2022 that spilled across asset classes from
equities to fixed income made it difficult for investors to find where to hide. But the “defining
characteristic” was the collapsing valuations in speculative growth stocks, said Scott Opsal,
director of research and equities at The Leuthold Group. It was the FANG platform groups that led
the implosion.

Typically, active fund managers diversify their portfolios to hedge against volatility. But since 2016,
themes such as cloud computing and disruptive innovation have taken Wall Street by storm,
catapulting firms into achieving sky-high valuations — including even those that had yet to turn a
profit. This made it close to impossible for funds that didn’t lean heavily into tech to outperform.
Meanwhile, index funds had no choice but to keep piling into those companies, even though they
looked expensive, and in the process helped to push them further. Tech’s glory days, however,
came to a halt in 2022 as the Federal Reserve launched its most aggressive tightening of monetary
policy in decades.
“The exorbitant valuations placed on mega-cap growth stocks created conditions favorable to
passive investing,” Opsal said. “But the 2022 bear-market reversal has now produced a climate of
fair winds for actively-managed portfolios.”

Data from Bank of America Corp. earlier in January show 47% of US large-cap active funds
outperforming their respective Russell benchmarks in 2022, ushering in the best year since 2017,
including 61% of “core” funds, with no bias toward either growth or value. There were 36% of them
also beating the S&P 500, which tends to be a much harder benchmark. The same story was seen
with small-cap active funds, which saw 72% best the Russell 2000:

There’s further evidence that 2022 represented a one-time correction from an unprecedented

degree of concentration. Unusually, most stocks beat their benchmark. “Despite a down market,
breadth was unusually healthy: 58% of stocks outperformed a benchmark that was (and still is) top-
heavy with mega-cap tech laggards,” Bank of America strategists led by Savita Subramanian said.
“Market breadth of 50%+ means that even a dartboard approach to stock selection offers a higher
likelihood of positive alpha.”

The S&P remains very concentrated by historical standards, even if it has retreated from the
extreme conditions that came with the post-pandemic rally. Thus, Subramanian warns, this
was not a fluke. In 2023, she expects this trend to continue.

There’s a further reason for optimism for active managers. Usually, their chances of
outperformance are driven by two factors: dispersion, or the total range between different stocks’
returns, and correlation, or the extent to which stocks tend to move together. Higher dispersion
and lower correlation give them a much better shot at beating the market after fees (and also, of
course, of doing very much worse). Last year, everything seemed to go down at once, and
dispersion was below average:
So active managers managed to make “alpha” (returns over and above the market) despite
conditions last year that would make this harder to do. As for correlation, it tends to rise when big
top-down factors are driving the market. In practice, when the economy is in trouble, or when
there is a financial crisis, correlation rises (and hence it grows harder to beat the market after fees).
Last year, as we know, was a top-down year. The rise in interest rates drove unusually high (if not
extreme) correlation:
Generally, the shorthand way of thinking of markets is that sometimes they benefit stock pickers,
and at others they benefit macro managers who aim to make their money through superior asset
allocation, rather than by selecting stocks. In practice, the very strange conditions since the 2008
crisis have made a nonsense of that dichotomy. With interest rates at rock-bottom levels, the logic
of TINA (There Is No Alternative to stocks) has held good. Diligent stock pickers and clever macro
fund managers alike have been rendered powerless to do anything like as well as a simple
investment in the index. Just as stock pickers investing only in equities endured a decade of
persistent underperformance, so did macro hedge funds. These funds looked very clever for
avoiding the stock market implosion that came with the bursting of the dot-com bubble in 2000,
held their own during the ensuing bounce back, and then looked clever again during the all-out
disaster of 2008. Since then, however, Hedge Fund Research’s index of macro funds has endured
spectacular underperformance of the S&P — until 2022:

Macro Investing Looks Smart Again

Macro hedge funds beat the stock market in 2022, breaking a long streak
 HFR Macro Index/S&P 500

300

200

100

1998 2010 2020

Source: Bloomberg

So 2022 was the year when both macro asset allocators and bottom-up stock pickers won again for
the first time since the Global Financial Crisis. That does make it tempting to suggest that this is
more than the inevitable occasional moment when you or I can beat Michael Jordan in a free-throw
contest. It’s just possible that over the last decade, the court has been tilted in such a way that was
even harder than usual. How to break down the arguments on this?

The possibility that this really is a change in the tide rests on two conjectures. First, low interest
rates distorted the market, and now we should witness a reversion to the norm. That’s at least
plausible. Second, the growth of passive funds has itself made it harder for anyone to beat them.
Money is flowing in to these funds, and they put that money to work at whatever the current price
is, regardless of valuation, thus at the margin favoring those stocks that are already overvalued. On
this argument, passive investing becomes a huge driver of momentum in the market. 

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Is this latter conjecture true? For at least two decades now, academics and investors have been
searching for “Peak Passive” — the point at which the proportion of passively managed funds
becomes so great that market efficiency breaks down. At this point, with rampant mispricing, it
should be possible for bold active managers to make money. Nobody has come up with a
satisfactory estimate of when this point is reached, but it’s hard to see how this can happen until
first the index outperformance reverses (which seems to have happened last year thanks to
correction to the excessive concentration in FANGs), and then money starts to flow out of passive
(which definitely isn’t happening so far).

Active fund managers can hope: The Cavs beat Michael Jordan that night, 113-112.  Photographer: Jonathan
Daniel/Allsport/Hulton Archive/Getty

High correlation and low dispersion suggest that a big attempt to return some logicality to market
pricing hasn’t started yet. Last year, we saw a massive correction to the sectors that enjoyed the
most extreme speculation in the immediate aftermath of the pandemic (add crypto, meme stocks,
and over-hyped “disruptive” tech stocks to the FANGs). We didn’t see a big reversion to the norm
for valuations that had built up over the previous decade. 

If investors truly begin to lose faith in passive funds, then a few years of big outperformance for
stock pickers really could happen. This might be part of the return to normal after the weird low-
rates decade. But nothing is given. And the basic mathematics of trying to beat the market are
unchanged. Even if there are no longer flows into passive funds to boost momentum, it will still be
very hard to beat the market after fees, and the game of fund management will continue to be a
zero-sum game (or perhaps “losers’ game”). 

Over time, Lazzara of S&P shows that the proportion of active managers who beat their benchmark
tends to dwindle. Repeat the game enough times, and the Michael Jordans will win. That means a
very few active managers, but mostly it means the index itself:
Yes, it’s possible that this is the moment when the anomalies created by both the excessive move
into passive funds and the equally excessive persistence of low interest rates are finally corrected.
This does look like an opportunity. In the longer term, it will still take exceptional skill to beat the
market.  

—Reporting by Isabelle Lee

Survival Tips
It’s time to wish everyone a happy Year of the Rabbit. Appropriate listening: White Rabbit by
Jefferson Airplane (or as covered by Pink), Bright Eyes by Art Garfunkel, The Cutter by Echo and
the Bunnymen, Rabbit Hole by Arcade Fire, Rabbit by Chas & Dave, Saint-Saens’ “Carnival of the
Animals” as presented by Bugs Bunny (and Daffy Duck), Swing the Mood by Jive Bunny and the
Mastermixers, or Rabbit Run by Eminem. If you have the stomach for it, you could also watch this
uniquely disturbing scene from Fatal Attraction. Or you could try the gritty Mexican thriller about
kidnapping, Conejo en la Luna (Rabbit in the Moon). Or for much lighter fare there is the genius of
Wallace and Gromit in The Curse of the Were-Rabbit, or singing and dancing by Bob Hoskins and
any number of cartoons in Who Framed Roger Rabbit. And of course, never make the Pythonesque
mistake of underestimating a rabbit. So, here’s wishing a very happy new year to all those who
celebrate it, and a great week for everyone.

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Want more from Bloomberg Opinion?  {OPIN <GO>}. Web readers click here.

— With assistance by Isabelle Lee

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its
owners.

To contact the author of this story:

John Authers at jauthers@bloomberg.net

To contact the editor responsible for this story:

Patrick McDowell at pmcdowell10@bloomberg.net

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