It’s always been tough to be a successful stock picker on Wall Street.
It’s not that mutual fund managers can’t beat the market, but it’s very difficult to do so year in and year out: Large-cap stocks have delivered long-term, annual realized returns of about 7% after inflation during the past 100-plus years. For the 15-year stretch through December 2016, 92% of U.S. large-cap, actively managed equity funds underperformed the S&P 500, according to data collected by S&P Dow Indices.
Even during April, the 25th best month of performance in the past 26 years for such large-cap managers, only 63% of mutual funds beat their respective benchmarks, according to Bank of America Merrill Lynch.
And the pressure on stock pickers is mounting because of exchange-traded funds, which feature lower trading costs and returns that are often competitive with or better than those of professionally managed funds.
Debating investing in individual equities or actively managed funds versus passive vehicles, such as ETFs? Here’s why it’s so difficult to pick a winner.
The fee hurdle
Before ETFs became so popular, mutual fund managers faced a simpler task: Pick stocks that performed better than the overall market, ideally better than the stocks their competitors picked. But with more investment choices comes more pressure. Active managers must now outperform by enough to make up for their funds’ higher costs relative to ETFs.
That additional burden can be significant. Equity mutual funds charged an average of 1.28% in annual administrative expenses — or what’s called an expense ratio — in 2016, compared with the 0.52% charged by the average equity ETF, according to data from the Investment Company Institute.
To match investors’ expectations from ETF returns, some portfolio managers create funds that mimic an index without completely duplicating it — what’s known as closet indexing. That can result in bloated or overly diversified portfolios that get dragged down by less-than-stellar picks. In addition, mutual fund managers often impose high redemption fees to discourage short-term trading, typically defined as holding shares for less than a year.
But costs alone don’t explain why stock pickers face such a challenge. Dynamics within the market also are partly to blame.
When unrelated assets move in lock-step — what’s known as correlation — it’s that much harder for stock pickers to find the ones that will go up even more than the average.
The past seven years have been tough in this regard. Among the 11 sectors of the S&P 500, the average correlation to the broader index ranged from 70% to 95% between 2009 and 2016, before dipping to as low as 57% in February and March, according to figures compiled by Convergex, a U.S. brokerage firm.
This has provided “some oxygen for active managers to outperform,” wrote Nicholas Colas, chief market strategist at Convergex, in an April report. Even Goldman Sachs has proclaimed the current market conditions — notably rising return dispersion — as a potential boon to skillful stock pickers.
The problem is, if analysts are right, these dynamics are likely temporary, which puts the longer-term fate of stock picking at peril. And remember, in addition to beating the market, active managers must also provide better returns than a comparable ETF to make up for their higher fees.
One theory got some buzz earlier this year: The odds are stacked in favor of indexes, and it’s not a fair fight for stock pickers.
Returns for a particular index are heavily skewed to a few of its biggest winners, so a portfolio manager generally must invest in these stocks just to keep up with the index’s performance. Picking a subset of stocks increases the odds those picks will underperform versus the index, according to a 2015 paper written by J.B. Heaton, Nick Polson and Jan Hendrik Witte, with a February update by Hendrik Bessembinder of Arizona State University.
“Active managers do not start out on an even playing field with passive investing. Rather, active managers must overcome an inherent disadvantage,” the authors concluded. And Bessembinder notes that compounding only increases that disadvantage over time.
There are many advantages of index-based funds and ETFs for individual investors. But that doesn’t mean you should dump all of your individual equities or actively managed funds and convert to just any passive vehicle. Not all index funds and ETFs are created alike. There are even some actively managed ETFs which come with higher fees.
Still, the explosion of these assets has given investors more options. If you’re dissatisfied with the longer-term performance of your mutual funds, consider making the switch. Do your homework first, paying attention to fees, commissions and the assets included in the ETFs you’re considering.
If you think you can beat the odds stacked against professional stock pickers, tread with caution. Don’t invest with money you’ll need for short-term expenses or put your entire retirement nest egg at stake.