(Bloomberg Businessweek) -- Consider two assertions about the much-maligned stockpicking industry.
First: Only 1 in 3 active managers can beat a nearly free fund tracking the S&P 500. Second: Active managers taken together possess discernible investing skill.
According to Hendrik Bessembinder, the Arizona State University professor whose research has upended much accepted wisdom about investing, both are true.
How that can be so goes back to the paper that's made him an academic lightning rod in one of the most fraught debates on Wall Street. To him, the case against active management has nothing to do with the world's best-paid professional investors being the equivalent of dart-throwing monkeys or pawing cats.
Rather, the thing that condemns the vast majority of stockpickers to futility is the market's own obscure math. It's a statistical concept known as skewnessโon vivid display this year.
โIt's kind of hard to make the argument that fund managers are just systematically stupid,โ Bessembinder says from his office at the W.P. Carey School of Business in Tempe, Arizona.
His best-known finding concerns the lopsided nature of market returns: Gains in just 72 companies have accounted for half of all net wealth creation from stocks, relative to Treasury bills, since 1926. In other words, the frequently lamented narrowness of the marketโin recent years characterized by, take your pick, FANG, FAANG, FAATMAN and the likeโis a permanent feature of investing. The reason is skewness, a term that means there are big outliers in a distribution of outcomes.
Skewness leads to a nearly insurmountable problem for the larger population of mutual fund managers. Effectively, it creates something resembling a scarcity of stocks upon which outperformance can be built. With most stocks falling short of benchmarks, so, too, do the funds that own them. โIt's hard-wired that there will be skewness, and when there is skewness, you're going to have the majority of the outcomes below the average outcome,โ Bessembinder says.
This effect has been especially large in 2023, even for a market that's been used to Big Tech dominance since the global financial crisis. The 20 largest stocks are contributing the most to S&P 500 index returns in more than two decades, according to JPMorgan Chase & Co. strategists. About 70% of the stocks in the S&P 500 lagged the index in the first half of the year, the most for a six-month period since 1999, data compiled by Bloomberg show.
Predictably, this year's scarcity of winning stocksโusually attributed to the narrow beneficiaries of the artificial intelligence boomโhas led to a lean season among winning funds. Just 36% of US mutual funds that invest in large-cap stocks are beating their benchmarks through July, Bank of America Corp. strategist Savita Subramanian wrote in a note this month.
There's some evidence for that link. According to S&P Global Inc.'s research spanning two decades, more active managers beat their benchmarks in years where the largest stocks lagged the index. โThe likelihood that most managers were overweight the mega-caps is pretty small,โ says Craig Lazzara, managing director at S&P Dow Jones Indices. โMost active portfolios are far closer to equal-weight.โ
New research by Bessembinder, co-authored with Michael Cooper at the University of Utah and Feng Zhang at Southern Methodist University, shows how pervasive this effect is over time. Out of 7,883 US mutual funds going back to 1991, just 41% beat the S&P 500 ETF each calendar year, while only 30% did so across three decades, the trio wrote in โMutual Fund Performance at Long Horizons,โ published in the . (Those percentages are higher than what's commonly reported because the paper compares active funds with actual index funds, which incur trading costs and expenses, rather than theoretical benchmarks.)
A conventional interpretation of those data might be that stockpicking is a racket, with any claim of investing prowess likely an illusion. And the work certainly fortifies the case for passive managementโparticularly given fees, owning an index fund looks like a better bet than ever in light of the research. What it doesn't do, however, is prove that mutual fund managers don't know what they're doing. Just as stocks spit out a precious few superstars to heavily burnish the performance of indexes, so, too, does the money management industry.
Bessembinder's paper shows the aggregate performance of all mutual funds versus the S&P 500 ETF over time. By his calculations, actively managed stock funds have returned 294% over their lifetimes, more or less matching the S&P 500โwhile the median fund posted just 95%. In other words, the superstars did the heavy lifting. Out of the entire sample, 442 delivered returns more than twice as large as the SPY, and 160 posted three times that. (Before feesโa purer way to gauge skillโthey posted 394% on average.)
In some respects, that makes sense. Because the universe of active funds is big enough to own all stocks, their performance will logically come close to that of the market itself. The way rewards are apportioned among managersโunfairly, by the laws of skewโcreates a backdrop where ridiculing high-priced investors for their inability to keep up with a preprogrammed index becomes a trifle too easy.
โOnce you realize the long-run returns are skewed, you realize that the upside is much bigger than you would've otherwise thought it was,โ says Bessembinder. โThat's what a percentage of active managers take as inspiration.โ
The skewness captured in his blockbuster paper in 2018 is so extreme because it spans the entire US market across many decades, and some have said its conclusions are sensationalized. But it's also won some key patrons. Baillie Gifford, the Scottish firm with $293 billion under management, hired the professor as a consultant after that paper, which he says supported the firm's instinct for making big bets.
In the modern economy, skewness might be down to the winner-take-all nature of dominant sectors such as tech. By that logic, market concentrationโand hence the hurdle for stockpickersโ might only get worse, as Bessembinder has found it doing in recent years.
But it's also partly a result of the long-term and dully mathematical effects of market swings: If a stock (or a fund) goes up 10% one month and then down 10%, it's still down 1%. If it goes down 10%, then up the same amount, it's also down 1%. But if it posts two consecutive months of 10% gains, it's up 21%. That's why the winners tend to widen their leads over time.
Two financial data scientists, Maxime and Vladimir Markov calculated just how dependent global stock markets were on their biggest winners from 2006 to 2021. They found that small-cap indexes were more dependent than large-caps, tech much more so than other industries. But the S&P 500 is also more skewed than European and Japanese large-cap benchmarks, according to their paper, which was a personal project posted online this year. (Vladimir Markov is an employee of Bloomberg LP, the parent of .)
To Lazzara at S&P, this kind of math is why active managers are better off with a broad portfolio that takes out, say, 50 of their least favorite names, rather than wagers on the 50 they like best.
Martijn Cremers, a finance professor at the University of Notre Dame who has consulted for active managers, agrees with Bessembinder's findings. โIt's only a smaller proportion of the assets that will be responsible for most of the outperformance, and that means that to be successful as an active manager in that environment, you have to be more concentrated,โ he says. โIt requires also more courage, stronger conviction.โ
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