Less-concentrated markets could buoy active managers

Returns for the U.S. equity market have been exceptional over the past decade, as measured by the Russell 1000 Index of large-capitalization U.S. companies. The index gained 13% per year on an annualized basis from 2015 through 2024 compared to 10.1% for the period from 1925 through 2024. By comparison, non-U.S. stocks (as measured by the MSCI AC World Index) and U.S. small-caps (as measured by the Russell 2000 Index) lagged the U.S. equity market over the past decade, gaining just 4.8% and 7.8%, respectively.

Much of the broad market’s performance has been driven by a small number of large technology-oriented companies, which have included “FAANGM” (Facebook, Amazon, Apple, Netflix, Google, and Microsoft) in the past and, more recently, the “Magnificent Seven” (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla).

As the figure below illustrates, the market-capitalization share of the 10 largest U.S. stocks has grown over the past decade; by 2024, these stocks accounted for almost 30% of the Russell 1000 Index. As a result, the performance drag from not owning those stocks—almost all of which are tech-related—has grown as well. In 2024, not holding the 10 largest stocks would have resulted in a performance headwind of –8 percentage points—the biggest annual drag for the period shown.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 

Heightened market concentration over the past decade has made it challenging for active funds, particularly large growth funds, to outperform. As the chart below illustrates, large growth funds are generally underweight mega-cap companies and overweight mid-cap, small-cap, and international stocks.

Several factors contribute to the structural underweight of mega-caps in active large-cap funds:

• Innovation and growth. Many fund managers believe that large, established companies are less innovative and find it harder to sustain high growth rates compared to smaller, more agile competitors.
• Alpha opportunities. There is a perception that information is less efficient in small-cap and non-U.S. stocks, leading fund managers to seek greater alpha opportunities in these segments.
• Regulatory constraints. The Investment Company Act of 1940 imposes rules that require diversified funds to limit positions exceeding 5% to less than 25% of the portfolio in aggregate, further contributing to the underweight in mega-caps.

The relationship between the performance of mega-caps and the percentage of active funds beating their benchmarks over time is negative. However, value managers have performed well by holding the Magnificent Seven, which are not part of their style benchmark.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 

The analysis that our team has conducted suggests that the headwind from mega-caps is only a small part of the underperformance story for many funds—and that for others, this headwind has masked good stock-picking elsewhere.

The table below shows performance attribution for two existing large-cap core funds benchmarked to the Standard & Poor’s 500 Index from 2014 through 2024. Both underperformed the index over the period, but for very different reasons. Fund A had significant exposure to international stocks (about 13% on average) and was underweight mega-caps (about 14% on average). Combined with a cash drag, these tilts created a headwind of –1.6 percentage points, which masked strong stock-picking within the remainder of the portfolio (+1.4 percentage points). Fund B, by contrast, had minimal exposure to international stocks and only a slight mega-cap underweight; most of its underperformance (almost 2 percentage points) came from poor stock-picking. 

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 

Should the next decade see mean reversion in U.S. mega-cap performance, as Vanguard’s capital markets outlook suggests, we would expect active managers to fare better in general.

However, not all active funds would benefit equally in such a scenario. Those that, like our Fund A, have had their strong stock selection masked during the last decade by the significant headwinds from an underweight to mega-caps could be poised to perform best. Conversely, those that are more similar to Fund B could continue to struggle. Value funds that have only outperformed through holding out-of-benchmark mega-cap tech stocks could also disappoint.

As investors reassess their active funds for the coming decade, we believe that making these distinctions about what, exactly, is driving an active fund’s performance will be critical.