Outperforming the stock market in the United States is difficult. Using the S&P 500, the benchmark index of U.S. equities, as the standard of performance, only 27% of actively managed large-capitalization equity funds beat the passive benchmark over the 12-month period ending June 30. Over the decade ending in June, just 13% of actively managed stock funds beat the broad S&P 500 index.
Management fees create an immediate hurdle. An S&P 500 index fund typically charges investors an annual fee of just 0.02% to 0.05%. An actively managed fund charges considerably more, often 0.5% to 1%. The active manager must overcome that difference every year just to match the index. Over the past several years, a small number of technology stocks, such as Nvidia and Alphabet, have generated a disproportionate share of the S&P 500’s returns. An active manager who is even slightly underweight in one of these technology giants can quickly fall behind the index.
Diversification rules can also work against active managers. The 10 largest companies in the S&P 500 account for about 40% of the index. A professional stock picker often cannot take on the risk of putting 35% to 40% of a portfolio into fewer than 10 stocks. Portfolio concentration increases performance risk and can reduce job security.
As winning stocks continue to outperform, their weights in the index automatically rise, increasing the passive fund’s exposure to them. An active manager is frequently less agile and can fall behind. Moreover, not being fully invested on just a handful of the market’s strongest days can wreak havoc on an active fund’s performance. Portfolio managers do not want to lose their jobs. They are well compensated. A stock picker who makes a risky investment that does not pay off in a timely fashion will face pressure from both management and investors. This creates a powerful incentive to avoid straying too far from the consensus.
Cash can also be a drag on performance. Professionally managed funds generally keep some cash available to meet redemptions. Because so much of long-term market performance is determined by a relatively small number of trading days, even a 3% to 5% cash position can meaningfully reduce returns. By contrast, an S&P 500 index fund is effectively always fully invested.
Over longer periods, the stock market is extremely efficient. Companies with high returns on capital and rapid earnings growth tend to attract enormous attention from investors. Thousands of analysts study the companies that make up the broad index. Finding genuinely new information that has not already been incorporated into stock prices is extremely difficult.
Human emotion is another important reason that so few professional managers beat the benchmark. It is difficult for an individual portfolio manager to bet against the consensus. Investing against the portfolio herd is difficult and can lead to termination if a non-consensus investment does not work out. Yet, on occasion, the market is simply wrong.
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Consider Moderna, an S&P 500 company. Most professional portfolio managers were skeptical of the pharmaceutical company. On Wednesday, Moderna announced positive results for its messenger RNA melanoma vaccine. Scientists have long known that mRNA technology offers considerable promise in treating cancer, but relatively few portfolio managers owned the stock. Moderna’s share price soared more than 100%. By definition, S&P 500 index funds already owned it.
The bottom line is straightforward: For most individual investors, purchasing a low-cost S&P 500 index fund remains one of the best ways to build long-term wealth.
The writer owns shares in Nvidia and Alphabet.
James Rogan is a former diplomat who later worked in law and finance for over 30 years. Now he writes a daily note on markets, economics, politics, and social issues. He can be reached at [email protected].