Market chaos gives skilled managers a chance to beat index funds - just like they're supposed to do

The 'set it and forget it' strategy is at risk in volatile markets. Savvy managers can dodge sectors your index fund is forced to own.

Uncertainty makes active investment management more valuable.

This is an opportune time for individual investors to reallocate part of their holdings to actively managed mutual funds, which may be better equipped to navigate current market conditions and potentially outperform their benchmarks.

The U.S. stock market is going through a somewhat unusual period. In addition to the increased volatility driven by the Iran war and policy uncertainty, recent market performance has been marked by a large divergence in returns across different sectors of the economy.

Amid these large market shifts, what should individual investors do? Conventional wisdom would probably say do nothing, if you hold a well-diversified portfolio - typically achieved by holding a broad market index fund in some combination with government bonds to achieve the desired level of risk.

Further supporting this view, academic research shows that active managers, who construct their own stock portfolios rather than passively tracking an index, tend to generate negative risk-adjusted returns once their management fees are considered.

But the current market environment may be one in which active management has a valuable role to play.

Uncertainty, divergent sector returns and high index concentration make active investment management more valuable. Institutions and other sophisticated investors often move money between sectors based on macroeconomic signals. Sector rotation follows certain patterns throughout the business cycle. In the later stages of the business cycle, more money is allocated into "defensive" sectors, which tend to be relatively stable regardless of economic conditions.

One issue with holding a broad market index is the increasing concentration of the U.S. stock market in a small number of giant companies. Five technology-sector stocks - Nvidia (NVDA), Apple (AAPL), Alphabet (GOOG)( GOOGL), Microsoft (MSFT) and Amazon.com (AMZN) - together represent about 25% of the S&P 500 SPX. Indexes typically weight firms by market capitalization, which makes it difficult to achieve true diversification across companies and industries by simply holding an index fund. To achieve greater diversification, investors may therefore need to hold a portfolio that differs from a benchmark index.

Individual stocks have different expected returns. These differences are often explained by how stocks co-move, or correlate, with a set of identifiable risk factors. A variety of such factors have been proposed in the academic literature, but one of the most enduring is the book-to-market factor, which captures the return differential between value stocks with low book-to-market ratios and growth or "glamour" stocks with high book-to-market ratios.

Active managers may be able to improve future returns by changing their portfolios' exposure over time.

More recent research suggests that returns to these risk factors may be partly predictable based on past data. If so, active managers may be able to improve future returns by changing their portfolios' exposure to these factors over time.

In our recent research paper, we examine the performance of active equity-fund managers over close to 20 years and find that some managers consistently earn higher returns by varying their exposure to common risk factors - an ability we call tactical investment skill. Managers who demonstrate this skill can significantly outperform otherwise similar funds, and this outperformance reaches close to 2% per year following quarters in which managers make large changes to their factor exposures.

When a handful of companies dominate broad market indexes and returns diverge sharply across sectors, a purely passive approach can leave investors too exposed to a single sector. Active management, by shifting capital allocation across sectors and avoiding excessive concentration in any one sector, may serve investors better than a low-fee index fund.

Relatedly, another important role of active management is directing investor capital toward more productive uses - toward firms and sectors of the economy with strong future prospects. In doing so, active managers can increase the overall value of the U.S. stock market, benefiting all investors, including those in index funds, while also helping increase economic growth.

Despite the continued academic focus on low risk-adjusted returns and the incentive problems associated with active management, the value of skilled managers during times of high uncertainty should not be overlooked.

Anna Scherbina is a nonresident senior fellow at the American Enterprise Institute and the Janet L. Yellen Distinguished Professor of Business at Brandeis University's International Business School. Jens Hilscher is a professor of agricultural and resource economics at University of California, Davis. Ting Bai is a former Ph.D. student at UC Davis.

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-Anna Scherbina -Jens Hilscher -Ting Bai

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