Inflation Is Coming — And Active Funds Aren’t Prepared, Bank of America Warns

More than half of actively managed U.S. funds lagged the S&P Composite 1500 last year, according to S&P Dow Jones Indices.

Illustration by II

Illustration by II

Actively managed funds aren’t positioned for rising inflation — which is coming, according to Bank of America Corp.

“They remain persistently overweight mega caps but underweight small caps,” Bank of America’s equity and quant strategists said in a research report Monday. That’s despite small-cap stocks being better positioned as the economy reopens from shutdowns during the pandemic, as well as having historically outperformed during the “mid-cycle” when inflation rises, they said.

A majority of actively managed U.S. large-cap funds failed to beat the Standard & Poor’s 500 index in 2020 for an eleventh straight year of underperformance, according to a report released last week by S&P Dow Jones Indices, a unit of S&P Global.

Amid expectations for an economic rebound this year, the Bank of America strategists estimated the U.S. has now shifted into a “mid-cycle” phase.

“In this phase, small caps and value have typically outperformed large caps and growth,” the strategists said in the report. “Small caps and value stocks were also some of the best-performing assets during the inflationary period of the late 60s.”

While equity investors have been rotating capital into value stocks this year, S&P Dow Jones Indices said a tumultuous 2020 for markets firmly favored growth, as the “the pandemic boosted the fortunes of those positioned to take advantage of changing lifestyles.” The S&P 500 Growth index returned 33.5 percent last year, crushing the “meager” 1.4 percent gain of the S&P 500 Value index, according to S&P’s scorecard.

A majority of actively managed growth funds beat their benchmarks last year, but their longer-term performance was dismal, the scorecard shows. Only four percent of large-cap growth funds outperformed over a 20-year period, compared to 10 percent of mid-cap funds and six percent of small-cap funds.

Most actively managed value funds also failed to beat their benchmarks over the two decades through 2020, while results for last year were mixed. While a majority of large-cap and small-cap managers outperformed in 2020, less than half of mid-cap funds managed to do so.

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More broadly, active U.S. equity funds were behind last year, adding fuel to the active-versus-passive investing debate.

“The turmoil and disruption caused by the pandemic should have offered numerous opportunities for outperformance,” said S&P Dow Jones Indices. Yet 57 percent of domestic equity funds lagged the S&P Composite 1500 last year, according to its report.

Now, with inflation pressures “percolating,” Bank of America says active funds are underweight its “pro-inflation screens” — or stocks most sensitive to rising inflation and likely to benefit in the recovery — and overweight its “anti-inflation screens.” Energy and materials are the most sensitive sectors to rising inflation, while areas such as consumer, industrials, and life insurance are also reflation beneficiaries, according to its report.

“The buyside isn’t there yet,” the bank’s strategists said.