Over the last 20 years, stock pickers have had a dismal record. Most haven’t come close to beating the overall stock market.
But occasionally, there are exceptions. In some periods, stock pickers rule, and the start of this year was one of those times.
In fact, it was the best January for actively managed stock mutual funds since Bank of America began compiling data in 1991. It wasn’t just that they turned in handsome returns for investors. The entire stock market did that. The S&P 500 and other stock indexes set records during the month.
It was that active stock funds did even better, though not by much, beating various market indexes by less than a percentage point, on average. Still, it was the best single month for these funds — in which managers buy and sell individual stocks whenever they choose to do so — since 2007. That happened to be the best calendar year for stock pickers in decades.
There’s no way of knowing how long this streak of outperformance will go on, or why, exactly, it has existed in the first place. But it’s quite possible that it will continue for the balance of the year, and that buying the average actively managed fund will look like a brilliant move. Index funds that mirror the entire market could well lag behind.
That said, I think the active fund managers are unlikely to prevail over the long run. The reason is that history shows it’s just too hard to beat the market.
A Random Walk
For a deeper perspective on market history, I called Burton Malkiel, the Princeton economist, who in 1973 wrote “A Random Walk Down Wall Street.” The book’s 15th edition came out last year, on its 50th anniversary.
“I wrote in that book that a blindfolded chimp could pick stocks as well as experts,” he said, with a laugh. He explained that he had never meant to denigrate stock pickers. He just wanted to make the point that while the stock market tends to rise over the long haul, no one knows what it will do day to day. So it’s fruitless for most people to try to outthink the overall market.
“The historical record shows that insight is basically right,” he said. It’s likely to be true in the future, too, he added.
Professor Malkiel is now the chief investment officer for Wealthfront, an automated investment firm that uses index funds and avoids stock picking. When he wrote “A Random Walk Down Wall Street,” though, no commercially available index funds were available; it would be three years until Jack Bogle at Vanguard started the first one. But Professor Malkiel, who later became a director of Vanguard, wrote back then that index funds would become the essential form of investing and that stock picking couldn’t prevail over the long haul.
The market is just too “efficient” for that, he told me. “That means information is quickly reflected” in prices, he said. “It doesn’t mean that prices are always ‘right.’ They’re not. They’re constantly changing. But nobody knows for sure whether prices are too high or too low, or where they’re going. There’s no way to know for sure. There’s too much going on. And this is why most active managers can’t over the long run do better than you can by investing in the whole market with an index fund.”
We spoke on Tuesday, shortly after the monthly report on the Consumer Price Index came in hotter than the market expected, and stock prices at that moment were falling. “This kind of thing happens all the time,” Professor Malkiel said. “Who knows where the stock market is going from here? I don’t think you can know.”
People on Wall Street viewed his perspective as outright “heresy” when he started to popularize it, and it is still somewhat “controversial,” he said, because many managers continue to try to beat the market, and while it’s difficult, some actually do.
“It’s certainly possible to beat the market,” Professor Malkiel said. And certainly there are some periods, as in January, when most active fund managers pull it off.
But the basic truth is that over periods of 10 years or longer, roughly 90 percent of active managers have failed to beat index funds, and those who have succeeded rarely repeated the feat for very long.
A Hot Streak in January
It’s hard to overstate how good January was for active managers.
No matter which major benchmark that Bank of America’s analysts used, active managers excelled.
Compared with the Russell 1000 index, which tracks publicly traded stocks with the highest market value, 73 percent of actively managed large-cap stock mutual funds had better returns. They outpaced the index by an average 0.57 percentage points. Similarly, 61 percent of actively managed stock funds outperformed the S&P 500.
The pattern held for investments in smaller companies, too. Among actively managed funds benchmarked to the small-cap Russell 2000, 86 percent beat the index. Against the Russell Midcap Index, 64 percent of actively managed funds did better.
How fund managers did it as a group isn’t clear, but there are some possible explanations.
For large-cap stocks, Bank of America found that active managers generally deviated from their benchmark indexes by concentrating in high performers like Microsoft and Meta, which rallied on investor enthusiasm about the prospects for harnessing artificial intelligence applications. The bank didn’t mention Nvidia, but the company, which makes chips that power A.I., outperformed the overall market, and a larger holding of its stock would move a fund ahead of the indexes.
At the same time, some large-cap stock funds reduced their holdings of Tesla and Apple, which declined in January in reaction to sales speed bumps.
But the relative performance of these and other companies is likely to shift, and when that happens, there’s no assurance that active managers will get their stock picks right.
A Little History
Since 2001, most active managers haven’t made the right calls.
As I’ve noted, a long-running and detailed study of fund performance by S&P Dow Jones Indices shows that active managers haven’t beaten the market. Through the middle of last year, active stock fund managers lagged the market:
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93 percent of the time over 20 years.
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90 percent of the time over 10 years.
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73 percent of the time over five years.
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72 percent of the time over one year.
Even when individual fund managers have beaten the indexes, they have rarely done so repeatedly and consistently. In June 2022, for example, not a single fund had finished in the top quarter of actively managed funds every year for five consecutive years.
One reason for this persistent failure is that actively managed funds generally have higher fees than passive index funds, and this chips away at their performance.
Nonetheless, actively managed funds have occasionally gone on streaks of outperformance. Since 2001, active managers have turned in better performances than the S&P 500 in 2005, 2007 and 2009. In 2007, the best year for active managers, 45 percent beat the index.
“It definitely happens from time to time,” said Anu R. Ganti, senior director of index investment strategy at S&P Dow Jones Indices. “It’s too early to say, but this could be one of those years. It’s just that based on the probabilities, active manager outperformance is not likely to happen for very long.”
I’ll be watching the horse race between active managers and the indexes closely, and I expect, personally, to settle for whatever the market averages bring. Beating the market is thrilling if you can do it. Falling behind is a lot less fun, and that, unfortunately, is what has usually happened to those who have tried to outsmart the market.
