More than half of large cap fund managers outperformed their benchmarks during the first half of the year, a remarkable comeback for active portfolio management. In fact, Bank of America Merrill Lynch says this is the first time this has happened since they started keeping data on it. They credit a handful of factors that drove this commanding outperformance among large cap fund managers, one of which was the massive size of their allocations to the FANG stocks (Facebook, Amazon, Netflix, Alphabet/Google).

Tech, Growth, Quality styles led in the first half

BAML Equity and Quant Strategist Savita Subramanian and team outlined these factors in a recent report. They noted that U.S. equities had their best start to the year in a long time as they continued reaching new highs in the first half of the year. In fact, stocks beat most of the other asset classes, with non-U.S. equities leading those other asset classes, even though there were some “defensive market internals” during the first six months of the year.

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large cap fund managers

For example, the two best-performing investment styles were Quality and Growth, and Risk and Small Size lagged the market.

large cap fund managers

The leading sectors in the S&P 500 were Technology which gained 17% between January and June. Health Care was a close second with a 16% gain, and Consumer Discretionary returned the third-best performance at 11%. On the other hand, the two worst-performing sectors were Energy, with a -13% return (although that's still a huge improvement from last year) and Telecom, with a -11% return.

large cap fund managers

However, the BAML team warned that the sector momentum could be shifting because volatility usually signals that a leadership change is about to happen. The VIX plunged more than 20% in the first half, although the uptick in June could be an early sign of a shift. Funds typically rebalance their portfolios at the end of a quarter, and they suggested that this rebalancing could be another catalyst that helps to trigger a rotation from crowded Growth stocks and into Value names.

Large cap fund managers made a huge comeback

The BAML strategists report that 54% of large cap fund managers beat their benchmarks in the first half of the year. It was the first time more than half of large cap fund managers outperformed their benchmarks in the first six months of the year.

large cap fund managers

In fact, they've picked up some strong momentum beginning in February, as June was the fourth consecutive month in which more than half of large cap fund managers outperformed, as 52% beat their benchmarks. According to Subramanian and team, this is the longest streak of beat rates greater than 50% since 2009.

Large cap fund managers might need to rotate sectors... and styles

They note that fund managers in general have remained steadily overweight on Tech, Discretionary and Health Care, the best-performing sectors in the first half of the year. Thus, sector positioning assisted them with their strong performances, especially given that their overweight positioning in Tech has been at record highs.

However, this could be a serious problem for large cap fund managers if they don't make some changes to their portfolios. According to the BAML team, they see risks that these funds' biggest overweight positions might start lagging stocks that active funds are underweight on. They warn that investors might begin to rotate out of what worked in the first half of the year, especially given the shift away from active investing styles toward passive.

This transition has been going on for some time and slowly picking up steam heading into the implementation of the Department of Labor's Fiduciary Rule.

large cap fund managers

Active or passive?

Despite the extremely strong performance of active stock pickers in the first part of this year, data from Morningstar indicated in February that over half a trillion dollars flowed into passive funds in the 12 months before. This backs up BAML's findings on active and passive funds and indicates just how far back this trend has gone.

Meanwhile, active managers recorded outflows of $13.6 billion, the firm added. Passive funds racked up $77 billion in inflows. The active drain has resulted in passive funds approaching the size of active funds by assets under management, as Morningstar said in February that active funds managed $3.6 trillion worth of assets, while passive funds managed almost $3.1 trillion. This puts passive funds on track to meet or beat active funds in assets under management, especially as

Implementation of the DoL Fiduciary Rule began on June 9, but more steps will go into effect next year. The BAML team warns that stocks which active managers are underweight on will likely benefit as investors shun active funds in favor of passive funds more and more.

What about the second half of the year?

BAML team expects the S&P 500 to be at 2,450 at the end of this year. Even though that doesn't suggest that there's much room for upside from where the index is right now, they still see "many opportunities" among U.S. stocks. For example, they expect Value stocks to beat Growth names as corporate profits improve throughout this year.

large cap fund managers

They also believe investors could start rotating out of the "crowded, expensive secular growth stocks that won in 1H." Another potential shift that BAML didn't mention is a sudden, jarring reversal of the trend toward active management from passive. BMO told Morningstar on Tuesday that they're starting to sell passive funds. This seems to run counter to the argument that the DoL will keep the flow from passive funds into active ones.

However, it's only natural for investors to start salivating for gains at this point, as BAML and many other sources have pointed out how well large cap fund managers and other active managers have done this year. The problem with active management is that the portfolio managers have to do well enough to make their fees worth owning their funds, but this year's strong gains could be strong enough to turn investors' heads, if BMO's sales of passive funds are any indication. And BMO isn't the only investment bank to predict that passive assets will fall. London & Capital Group made the same forecast earlier this month.

Sectors for the second half

As far as sectors, BAML likes Financials and Health Care the best; these two sectors are the firm's biggest sector overweights. They prefer Financials based on cash return plans and reduced regulatory requirements, a key part of President Trump's election platform. Major U.S. banks have already begun to boost their capital return programs since their stress tests this year indicated much greater financial health. The BAML team sees Health Care as "cheap, very underowned vs. history and our preferred alternative to Tech for secular growth."

They expect the Federal Reserve to hike interest rates again and predict that firms will begin normalizing their balance sheets. In this macroeconomic environment, they like dividend growth stocks

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