Whether it’s equities or fixed income, there’s no denying that active management is a difficult endeavor. Indeed, there are some asset classes that are conducive to active management – opaque corners of the bond market and small-cap stocks among them.
Still, while it might be trite to say, if securities selection was easy, everyone would be doing it. Fortunately, not all investors are doing it because it isn’t easy. Consider the following. As of December 2023, the average yearly return for the S&P 500 over the prior century was 10.54%. In any given year, that’s a tough tally to beat. To regularly do so is even more difficult.
Difficult, but not impossible. Another fun fact (data accurate as of last September) is that Warren Buffett’s Berkshire Hathaway could crater by 99% and still have beat the S&P 500 over the prior six decades. Borrowing an acronym from the world of sports, Buffett is one of the GOATs – greatest of all-time.
Thing is, GOATs aren’t born every day. Sports and the mutual fund industry prove as much.
Exploring Stock-Picking Difficulties
It’s not opinion that stock-picking is hard. It’s fact. Data confirm as much.
For the 10 years ending 2024, “only 10% of mutual funds saw more than half of their stock picks beat the index. This means that 90% of funds picked more losing stocks than winners,” notes Morningstar’s Jack Shannon.
He’s referring to the histories for all funds in the nine Morningstar Style Box categories. An expansive lot to be sure. Add to that, a decade is more than sufficient in terms of gauging success.
“When bundled together, the stock-picking record of active managers is not inspiring,” adds Shannon. “My research tracked more than a quarter of a million unique positions in large-cap funds between 2013 and 2023. Of those positions, only 44% beat the index over the period in which funds held them. Small-cap managers fared slightly better, as 46% of their nearly 160,000 unique positions topped the index over their holding periods.”
What Shannon is describing is the “hit rate,” or the rate at which an active manager selects winning stocks. Perhaps to the surprise of some clients, passive funds aren’t much better at “picking winners” though that’s not the purpose of such products. However, that lack of success breeds conditions such as a small number of stocks (think the Magnificent Seven in 2023) contributing large percentage of an index’s returns while other components lag.
Where Stock-Picking Can Work
Hindsight is 20/20, but historical data indicate an active manager’s ability/inability to pick winners matters less in the large-cap growth space because, as the Magnificent Seven proved last year, big bets on a small number of stocks can benefit fund holders.
“From that standpoint, large-growth managers actually seem to have a better eye for finding winners than the market at large, as shown above. At the fund level, nearly three fourths of large-growth funds had higher hit rates than the market’s 39% hit rate (that is, what a passive investor would’ve experienced),” concludes Shannon.
Problem is many large-cap growth managers don’t enough of their big winners such as Apple (NASDAQ: AAPL), Meta (NASDAQ: META) and Nvidia (NASDAQ: NVDA).