Why fund managers struggle to outperform the stock market
This market is favorable for stock pickers. So why aren’t more stock pickers achieving better results?
On paper, active fund managers, who strive to select the most promising investments and steer clear of the least favorable ones, should thrive in situations where certain stocks move in opposite directions and the disparity between the top performers and underperformers is significant. Based on certain indicators, this is the type of market we are currently experiencing. According to an index of implied correlation from Cboe, the Chicago-based exchange, it appears that the level of correlation between stocks moving up and down together is currently at historically low levels.
Meanwhile, according to a recent report by my colleague James Mackintosh, there is an unusually high level of dispersion in the returns of individual stocks, indicating a wide divergence from the average. When stocks exhibit reduced correlation and greater dispersion between winners and losers, it presents an opportune environment for stock pickers.
On the other hand, active funds are facing significant challenges. This challenges a fundamental belief on Wall Street, which suggests that active management is worth the extra cost and that stock pickers will consistently outperform the market. The challenges faced by the funds serve as a reminder of a fundamental principle: the success of the asset-management industry relies heavily on effective marketing rather than market conditions.
In this supposedly perfect investing climate, stock pickers are performing even worse than usual. According to Morningstar, in the first half of 2024, a mere 18.2% of actively managed mutual funds and exchange-traded funds were able to outperform the S&P 500, as they had hoped to do.
The percentage has decreased from 19.2% in the first half of last year to 19.8% in all of 2023. On average, less than 30% of actively managed funds were able to outperform the S&P 500 over the past ten years. There are several factors contributing to the underperformance of stock pickers. Correlation, the measure of the collective movement of stocks, may not be as low as indicated by the Cboe index. That’s because correlation can be measured in various ways.
Jeremy Raccio, a senior portfolio manager at UBS Asset Management, analyzed correlations within the S&P 500 back to early 2000. He used realized returns instead of implied volatility, which is a measure of fluctuation commonly used by Cboe. Stocks have shown a slightly lower level of correlation in recent years compared to 2022 and 2023, but this is still within the typical range observed historically, according to Raccio’s findings. Throughout the entire index and among the top 50 companies, it was observed that the stocks are exhibiting a similar level of correlation as usual. “It appears to be relatively consistent across different time periods,” he remarks.
According to data from Dimensional Fund Advisors, correlations among stocks are currently at historical averages. One observation: Asset managers tend to reference data that supports their narrative. Stock pickers are more than willing to cite statistics that suggest stock pickers should thrive. It is quite evident that active managers are currently underperforming due to their inability to outperform the current market.
As of this week, the three largest stocks in the S&P 500, namely Microsoft, Apple, and Nvidia, accounted for almost 21% of its overall market value. Five stocks had a share of 27%, while the top 10 made up over 36% of the total. Asset managers typically aim to mitigate risk, and having such a large amount of money invested in only a handful of stocks goes against this principle. Most clients would likely terminate the services of a fund manager who invested more than 20% of their funds in just three stocks.
A mutual fund that is heavily focused on its top few holdings would be close to the point where federal regulators no longer consider it diversified. Actively managed U.S. stock funds typically allocate around 14.2% of their portfolio to their top three holdings and 20.8% to their top five, as reported by Morningstar. These figures indicate a lower level of concentration compared to the S&P 500.
The market’s largest companies have experienced significant growth, as they have consistently outperformed other entities. Dispersion, which measures the variation in returns among individual stocks, has now become a reflection of a few successful stocks compared to many underperforming ones. The rest of the market appears to be the complete opposite of those few giant technology stocks. During the second quarter of 2024, the S&P 500 experienced a 4.28% increase, thanks to the influence of big tech. However, the Russell 2500 index, which monitors small and midsize stocks, saw a decline of 4.27%.
In the first half, S&P Dow Jones Indices reported that Nvidia single-handedly contributed to almost one-third of the total return of the S&P 500. A significant portion of the market’s return can be attributed to Microsoft, Amazon.com, Meta Platforms, and Eli Lilly, as these five stocks accounted for 55% of the overall return. Traditional measures such as correlation and dispersion have become less meaningful and relevant. The current market is heavily influenced by the 10 largest stocks, leaving those who don’t own them at a disadvantage, at least for now.
Portfolio managers can discuss at length the shift towards a market that favors stock selection. However, unless they selected precisely these stocks—and unless they selected substantial quantities of precisely these stocks—they will not achieve superior performance in the near future. Regardless of how fund managers manipulate statistics, they cannot alter the undeniable truth.
