Wall Street Learns That This Year, Nothing Beats Owning the S&P 500

In the closing chapters of 2023, investors are embracing a straightforward lesson: simplicity prevails. Despite the myriad strategies, from sector selection to trendy options maneuvers and a strong focus on dividends, nothing has proven as effective as the straightforward approach of owning the S&P 500.

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The final stretch of this year has witnessed a 4% upswing, propelling the index's overall advance to 24%. Investors are redirecting their capital toward plain-vanilla stock funds, with equity exchange-traded funds (ETFs) experiencing an influx of nearly $69 billion in December. According to Bloomberg Intelligence data, this marks the most substantial monthly inflow in two years. The colossal figure of over $42 billion has been added to the largest fund tracking the S&P 500, the $494 billion SPDR S&P 500 ETF Trust (ticker SPY), putting it on course for its most significant month on record since 1998.

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This trend underscores the enduring success of a strategy that has stood the test of time — buying and holding the benchmark gauge, which is currently hovering close to new highs. Conversely, numerous supposedly defensive measures, employed in anticipation of market challenges, have faltered in the face of the relentless upward march of 2023, revealing themselves as market-timing strategies in disguise.

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Art Hogan, chief market strategist at B. Riley Wealth, emphasizes the pivotal role of a diversified portfolio, endorsing the S&P 500 as the most effective means to navigate the investment landscape. He notes that attempts to adopt a defensive stance based on recession fears at the beginning of the year proved counterproductive. The simplicity of the S&P 500, in contrast, has been a consistent performer.

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Despite initial expectations of subdued returns in 2023 following the challenges of 2022, the year unfolded differently. Economic resilience and a slowdown in inflation fueled a steady rise in stock prices throughout the year. Recent days have witnessed an acceleration of gains, particularly after Federal Reserve Chair Jerome Powell hinted at potential interest rate reductions in the coming year.

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Interestingly, even a week that included one of the S&P 500's worst sessions this year failed to impede the influx of funds. Despite a 1.5% drop on Wednesday, the index managed an 0.8% advance, marking its eighth consecutive week of gains — the longest winning streak since 2017.

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Seema Shah, chief global strategist at Principal Asset Management, acknowledges the aggressiveness of the market but views it as anticipated, especially following indications of Powell's shift in stance, which opened the floodgates to significant equity investments.

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Deutsche Bank's measure of aggregate equity positioning reveals a recent rise, pushing into "overweight territory." Systematic strategies are also increasing their stock exposure, surpassing average levels. Additionally, discretionary positioning, as indicated by Deutsche Bank's measure, has advanced, likely reaching the top decile of readings. Alongside substantial flows into equity ETFs, net call volumes in ETF options surged to the highest level in five years, according to the bank's data.

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David Kudla, founder of Mainstay Capital Management, characterizes the current market environment as almost a "melt-up." He notes that professional money managers, lagging behind their benchmarks, are seeking to catch up and capitalize on the ongoing rally. Retail money, previously parked in money-market funds due to high yields, is now entering the market, attracted by its strong performance.

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While overall equity funds have seen an infusion of $349 billion this year, slightly below the $398 billion of 2022, a noteworthy shift is observed. Four S&P 500 ETFs have captured more than a third of the flows, representing the largest share ever, according to Athanasios Psarofagis, Bloomberg Intelligence ETF analyst. This surge comes at the expense of sector-specific funds like energy and utilities, which have witnessed outflows of $12 billion, marking their worst year on record.

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This strategic shift is validated by the performance of various tactical investments throughout the year. Only 31% of "active-like" ETFs, spanning thematic funds, environmental, social, and governance (ESG) products, factors, and actively managed vehicles, managed to outperform the benchmark index in 2023. This sets the beat rate on pace for the lowest since 2014, according to Bloomberg Intelligence. None of the categories tracked by BI had a beat rate exceeding 50%.

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The success of broad-market indexes has overshadowed a challenging year for tactical investments, particularly those emphasizing safety. Options-linked ETFs, promising additional yield and initially favored by traders, experienced substantial inflows but delivered tepid results. JPMorgan's Equity Premium Income ETF (ticker JEPI), a prominent example, gained about 9% on a total-return basis, trailing the S&P by about 17 percentage points.

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Similarly, dividend-focused ETFs, which attracted over $60 billion in 2022 from defensive-leaning investors, faced a different fate in 2023. These funds garnered a mere $1.5 billion this year, one of the lowest hauls on record. Most funds in this category missed out on the tech-led rally and underperformed the S&P 500. Notably, the $18.8 billion iShares Select Dividend ETF (ticker DVY) returned just 0.8% after strategic bets on utilities and financial stocks failed to materialize.

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As investors reflect on the year, the prevailing sentiment is one of questioning the necessity of factor or sector-specific investing. The superior performance of the S&P 500 has prompted a reckoning, leading to a reconsideration of investment approaches. In the midst of a dynamic market environment, the enduring simplicity of the S&P 500 stands out as a beacon of consistency and reliability.