About 80% of the stocks in the Nasdaq Composite, according to Factset, are covered by Wall Street analysts. The largest and best-known have dozens of analysts scouring through the financial reports, conference calls and comments from insiders, and thus are “over-covered” in Wall Street lingo. For example, Apple (AAPL) has more than 40 analysts. With that much brainpower behind the analysis, one would expect that retail and institutional investors would have no trouble picking the best stocks and outperforming the broader market, but that is not the case.
Standard & Poor’s, the large index provider and market research company, publishes the SPIVA (S&P Indices Versus Active) report, which, true to its name, compares the results of active institutional investors against the benchmark indices behind the funds they manage. Unsurprisingly, the majority do not beat those benchmarks, and even the ones who do don’t keep their lead for long.
Over its 23-year history the SPIVA report shows that, on average, 64% of active large-cap fund managers fare worse than their benchmark (the S&P 500) in any given year. Some years witness truly dismal performances, such as in 2014 when 87% of analysts lagged behind the index. In 2023, “only” 60% underperformed, a result that the SPIVA report deems “benign” considering S&P 500’s reliance on a rather narrow set of stocks for its performance.
Perhaps this makes you think that success is a simple matter of choosing the “best” managers. Surely there are a bunch of below-par managers out there and a simple search should make it pretty clear which ones you must avoid. Sounds reasonable, but you’d be wrong.
Active managers who outperform the index one year tend to fall behind the next. After 3 years, only 20% of them did outperformed the index. And this doesn’t even mean that they do so in each one of those years; it rather means that their total return over the period exceeded that of the index, but it could have been lower in any one or two of those years. According to SPIVA, no manager stays in the top 25% of all managers, let alone outperform the index for 5 years in a row. Only just over 1% manage to stay in the top half. In essence, those demonstrating superior performance today are highly unlikely to replicate that success in coming year.
Bond funds show particularly awful results, with 98% of active managers trailing the general investment-grade bond benchmark. As I have remarked multiple times in this blog, bond funds often misconstrued as proxies for individual bonds. This is a fallacy. Unlike equity funds, which behave like their underlying equities, the mechanics of bond funds diverge significantly from those of individual bonds. This applies to both actively-managed and index-tracking bond funds.
Retail investors may not be familiar with the SPIVA report, but they surely noticed that active managers consistently deliver below their benchmarks. Unsurprisingly, investors moved a significant share of their assets from active funds to those that simply track the same benchmarks. The proportion of assets in index funds more than doubled from 22% in 2012 to 46% in 2022.
Although there are a number of mutual funds that track indices – Vanguard is a prominent example –investors have gravitated towards exchange-traded funds (ETFs), the vast majority of which are designed to track a multitude of indices.
According to the Investment Company Institute, Net inflows into ETFs exceeded $3 trillion from 2017 through 2022, while active mutual funds suffered net outflow of more than $100B. In 2022 alone, active mutual funds hemorrhaged nearly $1.2 trillion assets, while ETFs gained more than $600 billion. Retail investors seem to have little doubt of what they want.
The largest index ETF is SPY, managed by State Street. It tracks the S&P 500 and commands about half a trillion dollars in assets. iShares’ IVV and Vanguard’s VOO, also S&P 500 trackers, are not far behind with $450 billion and $420 billion respectively.
The S&P 500 that these three ETFs track comprises the stocks of the 500 largest U.S. public companies weighted by their market capitalization. As extensively discussed, just seven stocks account for more than a quarter of the index value, thus dominating its returns. Concerns that the valuation of those stocks has been stretched to unsustainable levels have investors worrying about a potential reversal affecting just those stocks.
An alternative version of the S&P 500 – the equal-weight S&P 500 – offers a potential remedy. Unlike its market-cap-weighted counterpart, each stock in the equal-weight version carries the same weight. The largest ETF tracking this index is Invesco’s RSP, which manages around $50 billion in assets. The equal-weight construction mitigates the dominance of a few stocks, and might appeal to investors skeptical that the divergence between the staggering returns of a few stocks and the rest of the market could persist for much longer.