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Chinks in the Armor

Written by Krisna Patel, CFA, and edited by Hanna Jackson

Active funds are not a one-man show.  Management firms combine supercomputing capabilities with a multitude of field experts who have earned credentials like PhDs, MBAs, and CFA charterholders.   Theoretically, then, these investment powerhouses have every advantage to produce funds that outperform benchmarks like the S&P 500®, yet they fail on a consistent basis[i].  I believe there are five major reasons why large-cap managers in particular fall short of the S&P 500®.

To illustrate the first reason, imagine a star high-school runner.  He has won the state championship the last two years, but his competition this year is fiercer than ever.  On the morning of the championship, he weighs in seven pounds above his optimal weight.  In order to win, he must compensate for the disadvantage of the excess weight.

The runner represents an active fund.  Every mutual fund keeps a percentage of its capital in cash to keep the daily transaction flow as efficient as possible.  This cash allocation is typically invested in short-term securities that come with low fixed interest rates (i.e., minimal returns).  “Excess weight” comes into play when a higher cash balance leaves less capital available for investing at a potentially higher rate of return.   When this happens, the fund must compensate for that loss of higher return in order to beat the index.

I turned to Morningstar Advisor Workstation to research the cash balances of large-cap blend funds and calculate their impact on performance.  Keeping in mind that Morningstar’s data may be unable to accurately track cash for several reasons, I excluded fifteen funds that showed a negative cash balance.  Cash allocations of the remaining 329 funds came out to an average of 3.37% and a median of 1.58%.[ii]  This means that if, for example, an index gained 8% over the year, the average active fund would need to have an 8.28% return just to match (not beat) the index.

Increased cash balances, however, often are not the only cause of drag in performance.  Active managers charge fees to their fund portfolio—fees that are not applicable to an index.  Looking at the institutional and no-load share classes of the above-mentioned funds, I found the average expense ratio coming out to 0.80% and the median to 0.74%.   I limited my search to those two share classes because they have the reputation of being the least expensive classes available to retail investors.  Unfortunately, the downside to those classes is that investors often have access to those classes only through the additional expense of an advisor.   Combining the average cash balance and expense ratio of large-cap funds, an active fund competing against a benchmark returning 8% would have to gain 8.35% in order to keep pace with that index.

Remember that high-school runner?   He might not be too worried about the seven pounds if he’s racing only two other athletes, but 100 competitors will drastically reduce his odds of winning.  The same applies to active managers striving to produce the top outperforming fund.

The cardinal rule for profitable investing is to buy low and sell high.  A common way to accomplish this is by purchasing undervalued stocks and waiting to sell them until favorable market movement makes the stocks’ price climb.   If every investor or manager, however, applies this principle and begins buying such securities, it gets increasingly difficult to find one still undervalued.

The effect of this competition is analogous to ants searching for a food source.  When one ant finds a crumb, it is not long before a line of ants forms to grab a share until the crumb is gone.  The more ants there are in the line or the smaller the crumb is, the more quickly it disappears.  Unfortunately, both circumstances of a higher ant population and decreased crumb availability in this analogy apply to the current accessibility of undervalued securities.

According to the Investment Company Institute’s 2018 Investment Company Fact Book, the total mutual fund count increased from 8,003 in 1999 to 9,356 in 2017[iii].  Additionally, an estimated 149,000 employees in the investment company industry in 1999 grew to 178,000 by the end of 2017. How has the number of publicly traded stocks, however, affected the proportion of fund companies and managers to undervalued stocks?

The Wilshire 5000SM index, “widely regarded as the single best measure of the U.S. equity market,”[iv] experienced its highest listing count of 7,562 on July 31st, 1998.  An overall decline in registered stocks has been reflected in the index with 3,559 constituents at 2018’s end.  This hasn’t been a recent turn of events either: the Wilshire index hasn’t had more than 5,000 stocks since December 2005.  This shrunken crumb of availability proves detrimental to the active manager’s continual hunt for overlooked, undervalued stock, thereby restricting the probability of their surpassing other funds and the index.

The final barrier in active outperformance relates particularly to the S&P 500®.  This benchmark is not an entirely passive index as the Index Committee regularly replaces company stocks based on their discretionary application of S&P® guidelines.  Over the last 26 years, the annual turnover ratio of the S&P 500® has averaged 4.38%[v].  Looking ahead, this average means that, in roughly 23 years, the index could theoretically be composed entirely of stocks not included in the current list of 500.  Large-cap active managers attempting to beat the S&P® are aiming for this moving target that is an extensively active index.

These five circumstances, in and of themselves, do not call for strictly passive investing but instead reveal weak points in the common assumption that active funds are the best bet for “beating the market.”  While some large-cap managers have been occasionally able to outperform the S&P 500®, it is becoming increasingly difficult as more money enters the market with fewer stocks available.  The odds of any continued success for large-cap managers are decreasing, and we must bear this in mind as we plan for the future.


Edited by Hanna Jackson, registered assistant to Krisna Patel

Past performance is not a guarantee of future results.  Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of 03/11/2019, based on the information available at that time, and may change based on market and other conditions. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness.  We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

Krisna Patel is an Investment Advisor Representative at Engage Financial Group--11622 North Michigan Road, Zionsville, IN 46077.

Securities and investment advisory services offered through Woodbury Financial Services, Inc. (WFS), member FINRA/SIPC.  WFS is separately owned and other entities and/or marketing names, products or services referenced here are independent of WFS.

[i] S&P Dow Jones Indices SPIVA® U.S. Scorecard, year-end 2018.  Published on https://us.spindices.com/spiva 03/11/2019.

[ii] Source: Morningstar® Advisor Workstation.   Data as of 02/25/2019.

[iii] Investment Company Institute® 2018 Investment Company Fact Book.  Published on https://www.ici.org/research/stats/factbook

[iv] Wilshire 5000 Total Market IndexSM Index Fact Sheet, December 2018.  Published on https://wilshire.com/indexes/wilshire-5000-family/wilshire-5000-total-market-index 01/28/2019.

[v] S&P 500® Capitalization Weighted Turnover.   Published on https://us.spindices.com/indices/equity/sp-500 02/28/2019.