Avoiding the Crowd Is a Good Bet for Beating the Stock Market

(Bloomberg) -- U.S. fund managers can enjoy outsize returns by focusing on “neglected” stocks, according to a study published in the latest edition of The Journal of Portfolio Management.

A portfolio that's long the least crowded and short the most crowded U.S. shares earned an annualized return of just under 19 percent between 1981 and 2012, the study by academics including the University of Windsor's Ligang Zhong showed. That compares with an annualized return of about 10 percent for the Standard & Poor's 500 Index over the same period.

The study uses a measure of crowding that compares the percentage of each stock held by actively managed mutual funds to trading volume. A high percentage of active fund holdings in a low-turnover stock would result in a high degree of crowding under this method.

“Surprisingly, the abnormal returns can mostly be attributed to the least crowded stocks, which have characteristics resembling stocks neglected by mutual funds,” according to the academics.

The most crowded stocks tend to be the smaller-cap value shares which are heavily invested in by active funds, while the least crowded are larger-cap growth stocks with lower investment from mutual funds. These least crowded shares are covered by fewer analysts and owned by fewer active fund managers, but they have slightly higher turnover, the study showed.

“The implication is that there is limited information about these stocks and mutual funds are not paying much attention to them,” the authors wrote.

Active fund managers have been struggling to hang on to assets as investors abandon them for index-tracking passive funds. In the first half of 2017, flows out of active and into passive funds reached nearly $500 billion.

To contact the reporter on this story: Cormac Mullen in Dublin at cmullen9@bloomberg.net.

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Brendan Walsh, Andrew Dunn