This week or next, millions of investors will be receiving statements reporting third quarter performance for their actively-managed mutual funds. Comparing active results to passive benchmarks has been a frustrating exercise more often than not. Two observations tell us that the third quarter is likely to be especially painful.
We first observe that dispersion is low. Dispersion gives us a way to gauge the difference between the “best” performing and “worst” performing stocks in a given market. When dispersion is relatively wide, the opportunities to profit from stock selection are relatively large; when dispersion is narrow, the opportunities diminish. We can grasp this immediately by contrasting October 2001 with December 2013.
In both months, the return of the Dow Jones Industrial Average was 3%. Yet it takes only a quick glance at the graph to understand that stock selection opportunities were much greater in October 2001, when dispersion was high, than in December 2013, when dispersion was at near-record lows. This is not a function of manager skill. The problem is that in a low dispersion environment, the value of skill goes down.
Our second observation is that in the third quarter of 2014, the average stock underperformed the market. This sounds oxymoronic, but in fact turns on an important subtlety. Capitalization-weighted indices like the S&P 500 tell us the return of the average dollar invested, not the return of the average stock. An equal-weight index tells us the performance of the average stock. The spread between equal- and cap-weighted performance tells us how much incremental return an investor could achieve by picking stocks at random. The higher the spread between equal- and cap-weight, the stronger the tailwind at the active manager’s back.
In the recent past, the most successful year for active U.S. equity managers was 2009, when nearly half of U.S. large-cap managers outperformed the S&P 500. More importantly for our purposes, the weighted average performance of those managers in 2009 was 28.9%, versus 26.5% for the S&P 500. This performance occurred in an extremely favorable environment, as the S&P 500 Equal Weight Index rose by 46.3%. Otherwise said, in 2009, the average stock in the S&P 500 outperformed the index by nearly 20% — an ideal environment for stock picking if ever there was one. Not surprisingly, dispersion for that year averaged 8.7%, well above its historical average.
How does this compare with current conditions? The table below shows a dramatic difference:
In contrast to the tailwind that the outperformance of the average stock often generates, in the third quarter, managers faced a headwind. Moreover, dispersion is quite low by historical standards, meaning that even managers skillful enough to navigate through the headwind are unlikely to generate large rewards for doing so.
Active equity investors are likely to be disappointed by third quarter results.