25 January 2022

Stock Indexing Racks Up Another Triumphant Year

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Among all mutual funds that invest in big U.S. stocks like those in the S&P 500, only 9.3% are beating the index through Sept. 30, according to Denys Glushkov, a senior researcher at Wharton Research Data Services at the University of Pennsylvania. Although the year isn’t over, that is well under the previous annual low of 12.9% in 1995 and the average of 38.6% over the past quarter-century. Data through Oct. 31 from Lipper, a fund-research firm, show results nearly as dismal.

Before deciding what to do, it helps to know what is causing active managers to underperform so poorly. Portfolio managers and industry analysts say several forces are at work—and most of them are probably temporary.

The average U.S. stock fund has 5% of its assets in non-U.S. stocks, according to Chicago-based investment researcher Morningstar. Markets in the rest of the world have trailed the U.S. by 14 percentage points so far this year. The S&P 500 has no holdings listed primarily on foreign exchanges but active U.S. stock funds do, and that alone accounts for about 0.7 percentage point of underperformance.

So far this year, the Russell 2000 index of small stocks is up 3.1%, including dividends, while the S&P 500 is up 13.9%—the widest gap in favor of large stocks since 1998. The returns for various industrial sectors have been fluttering around like poultry on the run. Last year, energy stocks were up 22.3% and utilities up 9%, according to S&P Dow Jones Indices. But with oil prices and interest rates falling in 2014, energy stocks had lost 3% even before they collapsed at the end of this past week, while utilities have gained 18.5%.

Another factor: the one-year average of a technical measure called “dispersion”—which tracks the difference between the returns of winning and losing stocks—is at its lowest levels in modern history.

If the best stocks don’t perform much better than the worst, it’s hard for stock pickers to distinguish themselves. If the S&P 500 keeps soaring like an eagle over the heads of most stock pickers, even the true believers in active management would have a hard time maintaining their belief. If stock pickers’ bad performance persists for, say, two more years, you’d have a huge reduction in the money allocated to active managers.

But low dispersion is driven largely by the market’s lack of sharp swings this year—which, in turn, appears to be fueled by low interest rates.  Meanwhile, index-fund investors shouldn’t get cocky about the margin by which they have beaten investors in actively managed funds. If small stocks outperform large ones, international stocks beat the U.S., and volatility revisits the market, active managers will regain some of the ground they have lost. And in the long run it can be easier for some investors to stick with a charismatic stock picker than with a faceless index fund.

Of course, most stock pickers are still likely to underperform a comparable index fund over time. But they aren’t going to look quite this bad all the time.

Click here to access the full article on The Wall Street Journal. 

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