This time was supposed to be different. This was going to be a stockpickers' market in which astute active investors would no longer trail the index and could show their mettle. Instead, active management has continued to underperform.
The efficient-market crowd says -- of course -- that most managers can't beat the market. But there's also an unappreciated structural problem dooming active managers these days: We have been in a period of "narrow markets" in which a few stocks -- the Magnificent Seven, or Apple, Microsoft, Google parent Alphabet, Amazon.com, Nvidia, Facebook parent Meta Platforms, and Tesla -- account for the lion's share of market gains. So, any manager who develops a well-diversified portfolio of stocks -- and that, after all, is what most managers are hired to do -- is inevitably doomed to underperform because many of the holdings beyond the Magnificent Seven can only drag down performance.
According to Morningstar, during the first half of 2024, only 18.2% of actively managed mutual funds and exchange-traded funds that have the cap-weighted S&P 500 index as a benchmark outperformed it. That's down from the 19.8% for all of 2023. Over the past decade, an annual average of only 27.1% of actively managed funds benchmarked to the S&P 500 outperformed it.
The prospects for active managers were particularly handicapped in the first half of this year because the Magnificent Seven accounted for nearly 60% of the total return on the S&P 500. Those seven stocks also accounted for more than half of the S&P 500 performance in 2023. Their outperformance means they have grown to represent some 30% of the total S&P 500 market capitalization. New York Magazine called this "the greatest concentration of capital in the smallest number of companies in the history of the U.S. stock market."
If you ran a concentrated portfolio, and if you held all seven, you'd be riding high. But most managers have a diversified portfolio in which no single stock typically can constitute more than 5% of the portfolio. That means if, by dint of wisdom or luck, you acquired your full allotment of the Magnificent Seven, that would only account for 35% (seven times 5%) of your portfolio. The other 65% would have to be made up of less-stellar performers, with many dragging down the overall results.
OK, you say, but all that's a first-half-of-2024 story; the Magnificent Seven have cooled off a bit since then, and in normal markets managers have a better chance of getting it right. But it turns out that normal markets are very frequently narrow markets. Before the Mag Seven, remember, there were the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google). Collectively, the average return for these five was nearly 50% in 2017, compared with the S&P 500 return of 21.8%. The FAANGs came to make up more than 10% of the S&P 500 market cap and accounted for 4.3 percentage points of the overall market's 21.8% return in 2017. During 2020, the FAANG stocks surged to 20% of the index's total market cap, the highest concentration in the S&P 500's history -- until now.
And before the Magnificent Seven and the FAANGs, there were narrow markets in the late 1990s: The "Four Horsemen" -- Microsoft, Cisco, Oracle, and Intel -- led the market higher during the tech boom of the late 1990s. In 1999, these four plus Dell Technologies accounted for some 42% of the run-up in the total market value of all 500 companies. Going back a half-century, while there were thousands of listed stocks, the "Nifty Fifty" -- names like Sears, Eastman Kodak, and Polaroid -- were among a small cadre of stocks generating disproportionate returns.
It turns out that narrow markets aren't new or temporary or unusual. Professor Hendrik Bessembinder of Arizona State University has evaluated lifetime returns for every U.S. common stock traded on the New York and American Stock Exchanges and Nasdaq for the 90 years since 1926. He found that just 86 stocks accounted for half of the total stock market wealth creation over this 90-year period. Meanwhile, less than half of the stocks in the universe generated any returns for investors, and only 42% earned more than risk-free Treasuries over the entire period. Put another way, less than 4% of the thousands of stocks in this universe accounted for virtually all of the market gains.
The prevalence of narrow markets suggests that building out a typical institutional portfolio of 80 to 100 stocks may inevitably diminish rather than enhance returns. But most managers know they need to present a widely diversified portfolio with dozens of names in it because a "concentrated portfolio" is a specialized product seen as too risky by most investors.
Some active managers have been notorious for closet indexing -- creating portfolios that almost, but not quite, mirror the S&P 500, thus guaranteeing that results that will never depart too much from their benchmark. But how can you build a closet narrow-markets portfolio? You could offer a concentrated portfolio, composed of, say, 25 stocks, and if you get most of the Magnificent Seven, or whatever group is the elephant in the room at that moment, you'll do well. But that's a big market risk -- and a big marketing risk.
In short, as long as markets are narrow, stockpickers have a daunting task.
Comments