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Stock Picking

MANY INVESTORS maintain an enduring belief in good old-fashioned stock-picking. The hope: If they invest with a collection of skilled mutual fund managers who each have a laser-like focus on one part of the market, they can earn above-average returns.

This approach has led to “style box” investing. Investors might buy a selection of U.S. stock funds that focus on large-capitalization, mid-cap and small-cap stocks. Within these three size ranges, they might purchase a top-rated growth fund, value fund and blended-style fund. That means they end up with nine different U.S. stock funds. Similarly, they might purchase a collection of mutual funds that give them exposure to foreign stocks and to the bond market.

A recipe for success? It seems not. S&P Dow Jones Indices, a division of S&P Global, puts out a regularly updated study comparing actively managed funds to appropriate market indices. Over the 20 years through June 2021, the vast majority of funds in the nine U.S. style boxes underperformed their benchmark index. The failure rate ranged from almost 78% for large-cap value funds to more than 96% for small-cap growth funds. Meanwhile, among international funds, the 20-year failure rate varied from 87% for global funds (which own both U.S. and foreign stocks) to 95% for emerging markets funds. The 15-year results for bond funds were almost as disheartening, with the failure rate running at 73% or higher in all but two categories. Even the most-promising category saw 64% of actively managed bond funds lag their benchmark index. The full data can be found here.

This market-lagging performance should be no great surprise. It isn’t easy to find market-beating stocks and bonds. Every trading day, investors pore over the market, hunting for bargains. If a stock is undervalued, it’s unlikely to stay that way for long. But while the search for winning stocks is often fruitless, it isn’t cheap. Many stock funds charge 1% or so in annual expenses and might incur another 0.5% in transaction costs, for a total of 1.5%. Sure enough, that’s the sort of shortfall you typically see each year when you compare funds to their benchmark index.

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