One of Warren Buffett’s most famous quotes comes right from the hip and underscores his mentor Benjamin Graham’s philosophy: “Price is what you pay, value is what you get.” Essentially, the quote provides context in terms of stocks, their valuations, earnings, and their future returns. It turns out the quote happens to be right on the money. Research shows that when stocks are expensive, their future returns are poor.
That could be a major issue considering just how expensive stocks are right now.
With future estimates for the market now trailing behind long-term averages, investors are looking at rethinking their portfolios. This is where active management and ETFs may have an advantage. Data suggests that going active during these periods of time could actually benefit investors, producing market-beating returns.
Expensive Stocks, Low Returns
It’s easy to forget in today’s modern times of round-the-clock trading, mobile apps, and $0 brokerage fees, but when you buy shares of a stock or index fund, you’re buying an ownership stake in the company. Shares represent a proportional ownership of the firm’s profits, sales, assets, etc. There are many ways to value these shares versus their current price.
One of the more common ways is via the price-to-earnings ratio. This can be done via both trailing and based on future earnings expectations. Here, you can quickly see how much you are paying for a stock based on its earnings—current or estimated.
And it turns out there is a huge relationship between future returns and just how much people are willing to pay for stocks.
When valuations are high, investors are essentially front-loading future earnings and earnings growth into shares today. They are preloading a company’s future. To continue moving a stock’s valuation higher or to even out a valuation to match those front-loaded earnings, it takes an ever-increasing amount of growth in excess of expectations.
When this occurs, stock returns are lower because it’s hard to increase earnings by an ever-increasing amount to justify high valuations. A recent paper from the Wharton School of the University of Pennsylvania puts actual data behind this phenomenon and underscores that when stocks are expensive, they don’t put up as much in the way of returns. 1
A Lower 10-Year Forecast
For investors today, they’re about to see Wharton’s research firsthand. The run-up of the last year or so based on the Fed’s potential to cut interest rates has made stocks kind of somewhat expensive. Today, the S&P 500 is trading at a forward P/E of around 22. That’s pretty expensive considering the long-term average since 1971 is just 17×. Today the CAPE ratio is over 300, again indicating expensive equities.
The problem is that high P/E is being met with other economic issues that could stagnate and reduce earnings growth. This includes the return of inflation to a more normalized rate, higher overall interest rates, and return to a higher neutral rate from the Fed as well as high corporate tax potential. Additionally, trends like reshoring expenses, rising climate change costs, and continuing growth of the private markets are all expected to hinder earnings growth.
That’s exactly the kind of stuff that makes high current valuations hard to overcome. As such, forecasts for equity returns over the next decade are poor. This chart from Northern Trust shows estimated return expectations for major asset classes. Overall, the asset manager expects developed market equities to return just 6.3% annually over the next decade, which is well below the annualized 11% return for the last decade. 2
Source: Northern Trust
And it’s not just Northern Trust making this prediction. Goldman Sachs, Bank of America, and Vanguard have published similar lower-return expectations for the U.S. and global stocks.
Active ETFs Provide the Answer
With these lower return expectations, investors are facing a big quandary. Indexing will leave them open to lower returns, potentially not meeting their financial goals.
However, this is a time for active management and active ETFs to shine. It turns out that expensive stock markets and those with lower return potential are prime times for active managers to apply their craft. J.P. Morgan notes that overall higher equity valuations have been driven by a handful of stocks. These firms make up the bulk of the S&P 500 and similar large-cap indexes.
Passive investors are stuck holding all of these firms, while active managers can dive deeper into the stock universe, change their weightings, and hold different firms. Additionally, they can hone in on quality names, those trading at much lower valuations, and those that are benefiting from secular trends. The combination makes active management a wonderful avenue to explore during these periods of lower future return expectations.
ETFs make the active proposition even better, as their lower costs reduce the fee hurdle for active management and help investors keep more of their return, which is an important factor in a low return environment. Moreover, tax cost savings from the ETF structure will also allow investors to keep more of what they earn.
Active Equity ETFs
These funds were selected based on their active approach to the U.S. equity markets. They are sorted by their YTD total return, which ranges from 10% to 26%. They have expenses between 0.12% to 0.59%, and assets under management between $200M and $12B. They are currently yielding between 0% and 9.5%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| NUGO | Nuveen Growth Opportunities ETF | $2.99B | 25.6% | 0% | 0.56% | ETF | Yes |
| FBCG | Fidelity Blue Chip Growth ETF | $1.43B | 21.3% | 0% | 0.59% | ETF | Yes |
| TCHP | T. Rowe Price Blue Chip Growth ETF | $595M | 20.3% | 0% | 0.57% | ETF | Yes |
| NUGO | Nuveen Growth Opportunities ETF | $2.99B | 20% | 0% | 0.56% | ETF | Yes |
| FQAL | Fidelity Quality Factor ETF | $879M | 17.9% | 1.1% | 0.15% | ETF | Yes |
| QGRO | American Century U.S. Quality Growth ETF | $1.03B | 16.4% | 0.4% | 0.29% | ETF | Yes |
| CGGR | Capital Group Growth ETF | $5.91B | 14.9% | 0.3% | 0.39% | ETF | Yes |
| VALQ | American Century U.S. Quality Value ETF | $207M | 14.7% | 1.7% | 0.29% | ETF | Yes |
| DFAU | Dimensional US Core Equity Market ETF | $5.28B | 14.5% | 1.1% | 0.12% | ETF | Yes |
| JEPQ | JPMorgan Nasdaq Equity Premium Income ETF | $11.8B | 11.2% | 9.5% | 0.35% | ETF | Yes |
| VFQY | Vanguard U.S. Quality Factor ETF | $307M | 11.1% | 1.6% | 0.13% | ETF | Yes |
| QINT | American Century Quality Diversified International ETF | $246M | 10.8% | 4.2% | 0.39% | ETF | Yes |
Overall, there is a direct correlation between expensive stocks and future returns. With current valuations stretched beyond historic averages and plenty of tailwinds facing the U.S. stock market, returns going forward could be less than many investors are hoping for. That’s a problem for those looking toward passive investments for their holdings. The answer may lie in going active. The ability to not look like an index gives active a huge win going forward.
The Bottom Line
Stocks are expensive. That’s a problem for future returns. With many analysts now calling for lower-than-normal equity returns, investors may want to get active with their approach. This sort of environment is perfect for those active managers and their ETFs to shine.
1 Wharton (August 2023). Why Stock Valuation Hinges More on Returns Than Future Earnings
2 Northern Trust (January 2024). Capital Market Assumptions: 2024 EDITION 10-Year Outlook
