(from Joe Light’s Your Money column in the Wall Street Journal dated 1/24/2014. Click here for the original post. Joe writes about investing and personal finance for the Wall Street Journal, specializing in mutual funds, brokerages and other investing topics. He is a graduate of Yale University. Follow Joe on Twitter @joelight.)
Active fund managers say that they’ll succeed this year because stocks aren’t moving in lock step. Here’s why they’re wrong.
Here we go again.
Every year, a chorus of investment professionals proclaims the arrival of a “stock-picker’s market” in which active managers will shine.
But the laws of math don’t change—no matter how much fund managers touting their skill want them to.
Market-capitalization-weighted indexes, such as the S&P 500, represent the sum total of every investor’s portfolio. That means that for every investor who wins a percentage point of return above that of the index, there must be an investor—or investors—who lose a point.
And though, at least on paper, it is possible for most active mutual-fund managers as a group to emerge as winners—by trouncing amateur investors, say—more often than not, they don’t.
Once management fees are factored in, the average actively managed fund loses to passive, lower-fee mutual funds and exchange-traded funds that track broad indexes.
“It’s simple math. For every active manager who overweighted Netflix, somebody else underweighted it,” says Larry Swedroe, director of research at the BAM Alliance, a network of wealth-management firms that use passively managed funds.
Champions of active management say stock pickers failed to beat the indexes in recent years because stocks have moved in lock step, as investors reacted to the Federal Reserve’s low interest rates and asset purchases by plowing into the stock market. As the Fed pulls back, and the returns of winning and losing stocks diverge, active management should again reign supreme, they say.
Some bond-fund managers are chiming in, arguing that rising interest rates will make it especially important for investors to buy active bond funds that can manage interest-rate exposure.
Neither argument has evidence to support it.
Historically, the fate of stock-picking fund managers hasn’t been tied to whether prices are moving in one direction or returns are landing all over the map. And in years when interest rates have risen, bond funds’ chances of beating the index have actually dropped.
First, take stocks. One way to judge whether they are moving in lock step is by looking at “dispersion,” a measure of how spread out individual stock returns are. The higher the dispersion percentage, the more likely stock returns are to differ.
Since 1991, the measure registered at about 7.1% on average, according to S&P Dow Jones Indices.
In 2013, the dispersion of stocks in the S&P 500 was only 5%, the lowest in that period. That might appear to support the notion that last year wasn’t a stock-picker’s market; about 49% of active U.S. large-cap stock funds beat the index, according to investment researcher Morningstar.
But historically, active managers have tended to perform badly, even when dispersion was above average.
In years when stocks had returns that were more alike than they typically are, for instance, about 34% of active funds have beaten the market on average in a given year.
By comparison, when stocks have acted very unlike one another, about 43% have, according to a Wall Street Journal analysis of data since 1991 from Morningstar and S&P Dow Jones Indices.
In 2001, for example, when stock dispersion reached 10%, only 38% of active U.S. large-cap stock funds beat the S&P 500.
“There’s more opportunity, but whether people actually [outperform] is a function of their skills,” says Dan Suzuki, U.S. equity strategist at Bank of America Merrill Lynch.
Beating Small Investors
Mr. Suzuki thinks that active managers could achieve outperformance this year at the expense of small investors and other kinds of funds, rather than at the expense of each other, thanks to falling stock correlations and widening performance spreads, among other factors.
A bigger spread between the best and worst stocks hasn’t helped active funds as a group, but it does tend to make good funds better—and bad funds worse.
Research by Craig Lazzara and Timothy Edwards of S&P Dow Jones Indices concludes that as winning and losing stocks separate from the pack, the returns of winning and losing managers also get better and worse.
“Dispersion doesn’t tell you whether managers as a group are good or bad. What it helps us understand is what the value of being good is,” Mr. Lazzara says.
To put it another way: Markets that aren’t moving in lock step give active managers more rope with which to climb above the pack or to hang themselves.
The problem is, research also has shown it is difficult to predict who will rise and who will choke.
What about bonds? Are bond managers poised to beat bond index funds because of their ability to protect against rising interest rates?
Here, too, the evidence is grim. Between 1976 and 2013, the average annual yield of 10-year Treasurys rose in 15 years, including last year, according to Fed data.
In those years, more than half of active U.S. taxable bond funds have beaten the Barclays U.S. Aggregate Bond Index only four times, according to Morningstar data: in 2013, 1999, 1979 and 1978.
Active managers had a slightly better track record in years when interest rates fell.
For investors, the takeaway should be that no matter the environment, active managers are no more or less prone to fail or succeed. Passive funds will outperform after costs.
As the spread between the best- and worst-performing stocks widens, investors who use active managers—either because their 401(k) plans don’t offer other options or because they still want to take a shot at beating the index—should pay special attention to how the funds perform, Mr. Lazzara says.
If a fund manager fails to justify his fees even in a stock-picker’s market, it might be time to fire him.