They have faced the stiffest possible headwinds.
Absolutely Fine, Relatively Miserable
Last month, Bloomberg's Matt Levine wrote, "The basic process of value investing is that you go look for stocks that are underpriced relative to their fundamentals, and you buy them, and you wait for everybody else to notice how underpriced they are, and you get tired of waiting, and you go to complain to the press about how undervalued your stocks are."
Indeed. However, Levine's lesson should be generalized. The basic process of active investing is to buy stocks the rest of the world doesn't understand, await other investors' enlightenment, become frustrated with their stupidity, and then complain about how index funds have ruined the market.
My sympathies are … slight. However, in some fairness to U.S. stock-fund managers' cause, they have struggled against every conceivable headwind. Not, of course, in terms of their funds' absolute performances, which have been terrific, but in terms of their relative showings, which have them in aggregate stumbling behind their benchmarks, year after year.
Aside from simply selecting better securities while keeping their risk profiles similar to those of the indexes against which they are measured, domestic-stock fund managers have three ways to win: 1) diversifying into different asset classes; 2) betting heavily on a few industries; and 3) spreading among several investment styles. Unfortunately, all three tactics are failing.
There's No Place Like Home
Forget about the first strategy, that of owning other assets. Nothing has been able to keep pace with U.S. stocks, which have appreciated with barely a hitch since their 2009 bottom, providing nothing but misery for those who have bet against that asset class. Fixed-income securities and almost all foreign stock markets have flourish during that time period, yes, but their gains pale in comparison to what U.S. stocks have accomplished.
Consider the lowest five-year returns among the diversified U.S. equity fund Morningstar Categories, large-value funds, against several possible alternatives: developed-markets stocks; emerging-markets stocks; intermediate-term bond funds; and cash (represented here by short U.S. government funds). None of the challengers came close. Virtually without exception, any U.S. stock fund that deviated from holding only domestic equities during the past five years regretted that decision.
On the bright side for active managers, industry performance has been much more varied. The top sectors (technology and healthcare) have gained more than 17% per year during the trailing five years, two areas (energy and precious metals) are down for the period, and several others have muddled along with only modest gains. Any fund manager who weighted technology or healthcare stocks significantly more than did the stock-market indexes stood a good chance of beating the benchmarks.
Except … those are already two of the three largest stock sectors, currently accounting for one third of market between them. Add financial services, which also performed well, and that's half the marketplace right there. Fund managers can easily have overweightings in smaller segments of the market without fear of making their funds top-heavy. But they hesitate to put more money into industries that already dominate their portfolios. It feels imprudent.
(The same holds true for individual stock positions. As a general rule, mutual fund managers hold less rather than more of the very largest companies, such as Alphabet GOOGL or Apple AAPL, partially to improve their portfolios' diversification and partially for the sake of being different. That policy, too, has hurt them, with the ongoing strength of the FANG stocks.)
Send in the Clones
The next strategy, that of spreading across various investment styles, can be thought of as the opposite of betting on industry sectors. The industry tactic increases the fund's absolute risk by putting more money into the same places, while adding stocks with other investment styles decreases absolute risk. However--and this is the point--style diversification increases relative risk. By looking less like rival funds in its category, a fund improves its chances of standing out. (Of course, "standing out" can cut both ways.)
But funds haven't been able to do so for several years now. There was a time when large stocks might zig when smaller firms zagged and when high-priced growth companies might beat--or trail--value stocks by 20 percentage points in a calendar year. Those times appear to be gone. During the trailing five years, The nine U.S. stock-fund categories have danced to virtually the same beat.
Curiously, the stock-fund categories have varied by less than the bond-fund categories. Although less than 170 basis points separate the five-year annualized returns of the nine style categories, that gap is more than 3 times as large with domestic bond funds. High-yield funds have gained 5.5% per year, while inflation-protected bond funds have actually lost money during that time period. (No small feat, that.)
Active managers can't even console themselves by achieving the same returns as competitors' (or their benchmarks') but with lower risk. Once, Morningstar's lowest-rated funds, those that earn but one star, were markedly riskier than the funds of other star rating groups. That distinction has disappeared. Just as investment-style returns have converged, so have U.S. stock volatilities.
Some will blame (or credit) these findings on the explosion in index investing, stating that index funds have propelled the U.S. stock market north, have most benefited the shares of the biggest companies in the largest industries and/or have caused the investment-style results to cluster. I find such explanations implausible. Suffice it to say that the past few years have given U.S. stock-fund managers ample opportunity to show that they can succeed through pure security selection without making major bets that distinguish them from the benchmarks that they track. They have failed that test.
But if active managers have struggled to win by making the small decisions--by picking up a great many nickels, in effect--they certainly will have opportunity in the future to triumph via the big ones. I will not predict when this current storm against active-management will end, but end it will.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.