This morning’s Wall Street Journal offered a partial explanation for the failure of most active managers to outperform their cap-weighted index benchmarks in 2014. The proffered explanation is that “the rally in U.S. stocks was generally led by giant-company shares, such as Apple Inc., which rose 40%.” Since most active funds are underweight most mega-cap stocks, the argument goes, “it’s logical the S&P  would outperform most active funds.”
Apple’s 40.6% total return far outpaced that of the S&P 500 as a whole (13.7%), so an underweighted position in the Index’s largest holding would clearly have hurt in 2014. The argument is fine as far as it goes — but it doesn’t go very far. If it’s fair to note that Apple outperformed, it’s also fair to note that Exxon Mobil — the second largest holding in the S&P 500 — recorded a total return of -6.1%. The impact of underweighting mega-caps depends on which mega-cap a manager chose to underweight.
An easy way to understand the overall impact of capitalization is to compare the total return of the S&P 500 (13.7%) with that of the S&P 500 Equal Weight Index (14.5%). Since the two indices comprise the same stocks, the superior return of the equal weight version tells us that, in 2014, weighting by capitalization hurt performance — in other words, that Apple was the exception, not the rule. That said, the 80 basis points spread is exceptionally narrow in historical terms. Since 2002, the average spread between the equal- and cap-weighted S&P 500 has been 3.8%, with positive results in 10 out of 13 years. This means that in most years, picking stocks randomly from among the constituents of the S&P 500 would have been a winning strategy. The same was true in 2014, although to a lesser extent than typically.
In 2014 as in most prior years, the underperformance of the average active manager is striking. And when random selection beats actual portfolio managers, their performance was even worse than you think.