Stock Picking

MANY INVESTORS HAVE 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 mid-2022, the vast majority of funds in the nine U.S. style boxes underperformed their benchmark index. The failure rate ranged from 85% for large-cap value funds to 98% for large-cap growth funds. Meanwhile, among international funds, the 20-year failure rate varied from 87% for small-cap funds to 96% for emerging markets funds. The 15-year results for bond funds were almost as disheartening, with the failure rate running at 71% or higher in all but one category. Even the most-promising category saw almost 58% 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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