Quality Investing and the Importance of Active Management

26 February 2025 by National Bank Investments

Active management continues to gain traction among investors seeking to outperform benchmarks while benefitting from a degree of protection against downturns.

The key advantages of active management:

Active managers strive to deliver a stronger performance than the market. They aim to generate returns adjusted for risk in excess of their funds’ benchmark.
Active managers try to avoid severe drawdowns by using various metrics to evaluate exposure and mitigate risks. They can prioritize downside protection through sector allocation and tactical hedging strategies.
Active managers enjoy the flexibility to seize opportunities when they arise by exploiting market inefficiencies that can result in mispriced stocks. They constantly monitor key indicators to make portfolio adjustments when conditions change.

The concentration risk of passive strategies

While the S&P 500 remains the foremost benchmark for the world’s largest and best-capitalized stock market, a new factor must now be taken into account when tracking its performance. The current narrow breadth of the index introduces an additional layer of risk into the equation beyond market fluctuations. Specifically, the significant weighting of the “Magnificent 7” stocks within the S&P 500 now presents a concentration risk for investors holding passively managed U.S. equity funds in their portfolios.

In the current increasingly concentrated U.S. market environment, an internationally diversified stock portfolio along with a Quality Investing approach could help navigate market turbulence and protect portfolios from significant downturns.

Graph showing weight of Magnificent 7 in S&P 500

Magnificent 7 stocks: Apple, Microsoft, Meta Platforms, Amazon.com, Alphabet, Tesla, Nvidia. Tesla included from 2021 onward.

Yearly rounded off average percentage weight of “Mag 7” stocks in S&P 500 index.
Source: NBI.

The core principles of quality investing

Graph showing quality outperformance by comparing MSCI ACWI and MSCI ACWI Quality

Gross returns of indices in basis points from January 31, 2010, to January 31, 2025. Source: NBI

Quality investing focuses on companies with the following characteristics:

Strong balance sheet: Companies with low debt levels that generate high returns on equity (ROE) and stable cash flows.
Consistent earnings growth: Firms with a history of stable and growing profits that demonstrate resilience across market cycles.
Competitive advantage: Businesses with high barriers to entry that are market leaders with a dominant position and durable pricing power.
Management quality: Leadership teams with a proven track record of capital allocation and strategic execution.
Attractive valuation: Best of breed companies with a stock price at or below intrinsic value.

By emphasizing these factors, quality investing seeks to minimize risk and maximize long-term returns.

Key takeaway

In an increasingly complex market landscape, investment advisors must continually evaluate strategies that balance risk and return while ensuring long-term value creation for their clients. Quality investing, combined with active management, provides a robust framework to achieve this goal. By focusing on companies with strong fundamentals and leveraging active decision-making, advisors can enhance risk-adjusted returns and protect portfolios from downside risks.

The information and the data supplied in the present document, including those supplied by third parties, are considered accurate at the time of their printing and were obtained from sources which we considered reliable. We reserve the right to modify them without advance notice. This information and data are supplied as informative content only. No representation or guarantee, explicit or implicit, is made as for the exactness, the quality and the complete character of this information and these data. The opinions expressed are not to be construed as solicitation or offer to buy or sell shares mentioned herein and should not be considered as recommendations.

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Quality Investing and the Importance of Active Management

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