If there’s one word that investors don’t want to hear, it’s the word “bubble.” Whether it’s tulips or tech stocks, bubbles imply overpriced assets, significant losses, and even the possibility of recession. So, the fact that the word bubble has started to creep back into the financial lexicon is worrisome for portfolios.
How can investors stay invested and sleep well at night?
Active management could be the answer. And history is on the active management’s side. Performing well during the Great Recession and dot-com bust, active management and active ETFs could be the best way for investors to get through the bubble bursting.
The Growing Bubble
Truthfully, there’s a lot of risk in the broader markets these days. This includes a host of factors, both macroeconomic and stock-market specific.
The macroeconomic factors are easy to spot. The economy is growing at a weird rate— moving fast enough to create inflationary trends but not fast enough to warrant rate hikes. This has put the Federal Reserve in the hot seat of struggling to maintain its soft landing and not push the economy into a recession. Compounding these issues remains potential policies from incoming President Trump. Analysts and pundits predict tax cuts and tariffs to be inflationary.
This uncertainty has been met head-on with less than noticeable risks. Rising stock market valuations and concentration risk have only been growing.
The promise of artificial intelligence (AI) and investors looking to repeat trends of previous low-growth environments has managed to ascend the technology sector to levels not seen in decades. Today, tech stocks have the highest concentration levels in major indexes in fifty years.
The Magnificent Seven of Apple, Microsoft, Alphabet, Amazon, Meta Platforms, NVIDIA, and Tesla have dominated market indexes and the market’s overall returns since the pandemic. As a result, these firms have increasingly dominated major indexes, weightings, and holdings. A decade ago, the seven largest stocks represented only 14% of the S&P 500, but today they account for nearly 33%. 1
The top-heaviness of these seven big-name tech stocks caused the Nasdaq 100 Index to undergo a “special rebalance” at the beginning of 2024 to avoid Securities and Exchange Commission (SEC) rules on fund diversification. This was only the third time in history that the index needed to do so. The two previous times were at the beginning of the dot-com boom and during the Great Recession.
While portfolio gains have been great during the good times, the question remains: What happens during the bad times? Large positions in these firms put investors — particularly those in index funds — at increased downside risk. One lousy quarter at Microsoft or a piece of less-than-ideal news from Google, and the index will fall significantly.
At the same time, the surge in these stocks has put pressure on valuations, leading to their extension. If the macroeconomic tide slips or if there’s a reversion to mean concerning valuations, the markets could plummet.
Active May Be the Answer
With concentration risk rising and valuations getting stretched, a bubble could be forming. For passive and index investors, this is a worrisome omen. When the bubble does pop, they could be in serious trouble. So, fighting the rising bubble and concentration risk is key.
And active could be the answer.
Looking at historical data, asset manager T. Rowe Price shows that active managers can add significant alpha during the “popping” of the bubble and in the quarters after. For example, looking at the dot-com bust of the late 1990s, when the combined weight of the top 10 stocks in the S&P 500 peaked at 25%, managers were able to add as much as 10% in 3-year rolling excess returns versus the passive indexes. This chart shows their findings.
Source: T. Rowe Price
Similarly, T. Rowe found that trends in active outperformance weren’t just isolated to the United States. Japan’s asset price bubble of the 1980s and the emerging markets rally of the 2000s saw rising asset prices mixed with index concentration before their collapse. In both events, active managers generated significant alpha during the downturn and years after.
The outperformance after the bursting of asset bubbles is that active managers don’t have to function like an index or hold stocks in proportion. This gives them total control. At the same time, they can pick and choose sectors as they see fit, including underweighting overpriced sectors and buying those that are cheaper. This allows them to avoid potential blowups before they happen, buy good stocks for cheap, and avoid concentration risk.
Active managers can also sell positions as they see fit, helping to limit losses. As a stock or sector gets too big, it can book gains before the downturn happens. This selling allows active managers to right-size positions for assets under management and future returns expectations. And if all else fails, managers can flee to cash when things hit the fan.
Active ETFs Enhance This Ability
The beauty is that active ETFs only enhance the ability of active managers to avoid blowups and add alpha during bursting bubbles. That’s because costs are dropping, while taxes are minimized.
T. Rowe Price notes that active fees have continued to drop, allowing for a lower fee hurdle for active managers. This is important during periods of strife in that every basis point counts toward a positive return for investors. Secondly, the creation-redemption mechanism allows for great tax savings if/when an active manager sells, flees to cash, or right-sizes their positions. Both points are key for active to deliver more significant alpha when the current/next bubble pops.
Active Large-Cap Equity ETFs
These ETFs were selected based on their lower concentration risks to the broader S&P 500. They are sorted by their 1-year total return, which ranges from 16% to 51%. They have expenses between 0.15% and 0.59% and AUM between $760M and $21B. They are currently yielding between 0% and 1.45%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| FBCG | Fidelity Blue Chip Growth ETF | $764M | 50.5% | 0% | 0.59% | ETF | Yes |
| CGGR | Capital Group Growth ETF | $2.84B | 34.5% | 0.38% | 0.39% | ETF | Yes |
| CGUS | Capital Group Core Equity ETF | $1.32B | 22% | 1.24% | 0.33% | ETF | Yes |
| DFAC | Dimensional U.S. Core Equity 2 ETF | $20.45B | 16% | 1.34% | 0.17% | ETF | Yes |
| AVUS | Avantis U.S. Equity ETF | $4.53B | 16% | 1.45% | 0.15% | ETF | Yes |
Active managers and ETFs can provide some comfort for investors in the current market environment. Macroeconomic risks are rising, while concentration risk reeks of a bubble forming. With active management, investors can gain excess returns in the post-bursting period. Active managers can remain nimble, not tied to an index, and provide a different set of returns to a portfolio. By adding in lower taxes, you have a recipe for success.
Bottom Line
The market is getting frothy. Perhaps too frothy. Concentrations and valuations are rising. Many pundits are now talking about a bubble forming. However, active ETFs may be the answer to those issues. Active management can win out with the ability to not look like an index, hold different stock concentrations, and sell before rebalancing.
1 T. Rowe Price (July 2024). Active investing is suited to the uncertain markets ahead
