With the Odds on Their Side, They Still Couldn’t Beat the Market

It’s awfully hard to beat the stock market consistently. In 2022, despite many advantages, most mutual funds couldn’t do it. There are important lessons in that failure for this year and beyond.

Recall that the S&P 500 declined 19.4 percent last year. It was a miserable time for just about anyone who held stocks, including those who merely tried to match the overall market, as I do, using broadly diversified, low-cost index funds.

But beneath the market’s surface last year, there were plenty of opportunities that should have given active stock pickers a competitive advantage over index funds. That’s because the average stock did better than the overall market, which was heavily influenced by a relative handful of “megacap” tech stocks like Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Nvidia and Tesla. These giants declined sharply, but the rest of the market did markedly better.

That meant the odds actually favored stock pickers last year. They had plenty of companies to choose from, any one of which would have given them a better performance than the overall market. And, in fact, as a group, actively managed mutual funds fared better against the overall market average than they have since 2009.

Even so, the average actively managed stock mutual fund failed to beat the S&P 500. In an interview, Anu R. Ganti, senior director of index investment strategy at S&P Dow Jones Indices, summarized that mediocre performance this way. “Actively managed funds underperformed less badly in 2022 than they have in most years,” she said. “But they still underperformed.”

Tailwinds Helped, but Not Much

In some respects, the failure of actively managed mutual funds to beat the broad market indexes last year is unsurprising. S&P Dow Jones Indices has been running systematic comparisons of actively managed funds and passively managed funds — a.k.a. index funds — since 2001.

These studies have consistently found that the vast majority of active fund managers just can’t beat the indexes over 10- or 20-year periods, or in most individual years, either.

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The decline of the stock and bond markets this year has been painful, and it remains difficult to predict what is in store for the future.

From 2010 through 2021, anywhere from 55 percent to 87 percent of actively managed funds that invest in S&P 500 stocks couldn’t beat that benchmark in any given year.

Compared with that, the results for 2022 were cause for celebration: About 51 percent of large-cap stock funds failed to beat the S&P 500.

Active managers couldn’t quite achieve what random chance would predict — that 50 percent of actively managed funds would beat the index.

In other words, their performance for 2022 looks slightly worse than the results of a random coin flip.

That’s unimpressive, but it was much worse over longer periods. Consider these tallies for funds that invest in S&P 500 stocks through the end of 2022:

Over three years, 74.3 percent of actively managed funds trailed the index.

Over five years, 86.5 percent underperformed.

Over 10 years, 91.4 percent underperformed.

Over 20 years, 94.8 percent underperformed.

As the numbers show, the longer you ran the horse race, the more actively managed funds fell behind.

Over 20 years through April 11, the SPDR S&P 500 E.T.F. — one of the many mutual funds and exchange-traded index funds that track the S&P 500 — returned nearly 10 percent, annualized. The vast majority of active, stock-picking funds couldn’t match that.

The Odds Have Gotten Worse

When you look carefully at the results for 2022, the performance of actively managed funds is much worse than it may seem at first glance, because it really wasn’t a coin flip.

For the stock market, 2022 was a special year. If there was any year in which stock pickers should have been able to outperform the broad market indexes, 2022 was it, yet most still couldn’t beat the battered stock market.

That augurs poorly for active managers in 2023 because, so far at least, the odds have shifted.

Once again, consider “megacap” tech stocks, which had terrible performances last year — much worse than the S&P 500 as a whole. The S&P 500 is a capitalization-weighted index, which means that the most valuable stocks in the markets, like those from the big tech companies, have an outsize effect on stock market returns. When they decline, the overall index tends to decline. When they rise, the overall market tends to rise. Often the market moves in lock step, with many stocks heading in the same direction.

But last year, the monthly “dispersion” of the S&P 500, which measures “the magnitude of differences” in the returns of individual stocks in the index, was at its highest level since 2009. This means that there was more variation in stock returns, and most individual stocks did much better than the megacap stocks. You can see this by comparing the standard S&P 500 with an equal-weighted version, in which a stock like Dish Network, with a market capitalization of less than $5 billion, has the same weight as a colossus like Apple, with a market cap of well over $2 trillion.

In 2022, the equal-weighted S&P 500 outperformed the standard index by nearly seven percentage points. That implies that if you just picked stocks randomly last year, you should have done better than the overall index because the typical random stock did better than the megacaps and better than the S&P 500. But most active managers couldn’t do it.

Their chances are worse this year because the market so far has been very different. Megacap stocks have been outperforming the average stock in the S&P 500 index, and the equal-weighted version of the S&P 500 has been trailing the standard, cap-weighted index. That implies that if you just pick stocks randomly, odds are that you will trail the overall stock market this year.

And, in fact, preliminary tallies by Bank of America show that in a horse race between active large-cap mutual fund managers and the S&P 500 this year, the active managers have been clobbered. Only 45 percent of active large-cap stock managers have matched the performance of the S&P 500. Stock pickers are doing better in some corners of the market, but for the most part, it’s a dismal picture

Improving Your Chances

It’s definitely possible to beat the stock market. A small number of people will probably to do it over the next 20 years. But I don’t know now who those outliers will be. Similarly, I don’t know the precise direction of the economy or of inflation or of the Federal Reserve’s interest rate policies or of a host of other monumentally important factors. No one else knows, either.

That’s why I think it makes sense to embrace humility, accept my limitations and use low-cost index funds to try to match the returns of the stock and bond markets over the long run.

To do that, and to withstand the wrenching shifts in the markets that will surely come, I’ll need enough cash on hand to pay the bills first. Money-market funds and high-yield, federally insured savings accounts and certificates of deposit are reasonable options for that purpose.

Make your own choice. Some active stock pickers will beat the market averages this year. But based on history, I think it’s virtually certain that the vast majority won’t manage to do it over the next 20 years.

Because I’m trying to improve my odds while investing for the long haul, I’m aiming for an absolutely average performance.

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