Why your fund manager can’t beat the stock market today

In theory, active fund managers who try to pick the best investments and avoid the worst should outperform when some stocks zig and zag while others do not, and when the gap between winners and losers is large.

By some measures, that’s the market we’re in right now: Cboe, the Chicago-based stock exchange’s implicit correlation index, suggests that the degree to which stocks are rising and falling in unison is near its lowest level on record.

Meanwhile, as my colleague James McIntosh recently reported, dispersion — a measure of how far individual stock returns vary from the average — is unusually high.

When stock prices move up and down in much less tangent than usual, and the spread between winners and losers is even larger than usual, that should be ideal for stock pickers.

Instead, active funds are struggling, upending one of Wall Street’s most cherished ideas: that active management is worth paying a premium, and that stock pickers will always do better in some periods than in others.The funds’ struggles are a reminder of a fundamental principle: the asset-management industry relies more on marketing than on markets.

First, despite this ideal investing environment, stock investors are performing even worse than usual: According to Morningstar, only 18.2% of actively managed mutual funds and exchange-traded funds compared to the S&P 500 in the first half of 2024 outperformed the index.

That’s down from 19.2% in the first half of last year and 19.8% for all of 2023. Over the past decade, actively managed funds benchmarked to the S&P 500 have beaten that figure on average just 27.1% of the time.

There are a few reasons why stock investing gurus are stinking worse than usual.

Correlation — a measure of whether stock prices are rising or falling in tandem — may not be as low as the Cboe index suggests because correlation can be measured in different ways.

At my request, Jeremy Lacchio, a senior portfolio manager at UBS Asset Management, analyzed correlations for the S&P 500 going back to the early 2000s, using realized returns rather than the implied volatility (a measure of fluctuation) that Cboe uses.

While stocks have moved a little less together recently than they have in 2022 and 2023, the difference is well within historical norms, Laccio said. For the overall index and the top 50 companies, stocks have moved together about as well as they usually do, he said.

“To be honest, every era looks pretty much the same,” he says.

Data from Dimensional Fund Advisors also shows that correlations between stocks are close to their historical averages.

One implication is that asset managers are eager to cite whatever data best supports their claims, while equity investors are happy to cite statistics that suggest equity investors should do well.

None of this can hide an obvious truth: active managers are underperforming because they cannot outperform today’s markets.

As of this week, the S&P 500’s top three stocks — Microsoft, Apple and Nvidia — make up roughly 21% of its total market capitalization. The top five stocks make up 27% and the top 10 stocks make up more than 36% of the total.

Part of an asset manager’s traditional job is to manage risk, and concentrating so much money in just a few stocks goes against that principle: Many clients would fire a fund manager who puts more than a fifth of their money in just three stocks.

It won’t be long before mutual funds with extremely high holdings in a few top stocks will no longer be considered diversified by federal regulators.

According to Morningstar, actively managed U.S. stock funds hold an average of 14.2% of their portfolios in the top three stocks and 20.8% in the top five stocks, both of which are significantly lower than the S&P 500.

Of course, the reason the market’s largest companies have gotten so big is because they have outperformed other companies by a large margin.

So variance, which tracks how far an individual stock’s return varies from the average, is primarily a measure of a few winners against hundreds of laggards.

The rest of the market looks the polar opposite to the few big tech stocks: In the second quarter of 2024, big tech companies led the S&P 500 up 4.28%, while the Russell 2500 index, which tracks small and mid-cap stocks, fell 4.27%.

Nvidia alone accounted for nearly a third of the S&P 500’s total return in the first half of the year, according to S&P Dow Jones Indices. If you add in Microsoft, Amazon.com, Meta Platforms and Eli Lilly, 55% of the market return came from those five stocks.

This means that traditional metrics like correlation and dispersion have lost much of their meaning and almost all relevance. The top 10 stocks now dominate the market, and anyone who doesn’t own those stocks is left behind, at least for the time being.

Portfolio managers can talk all they want about the stock market becoming a stock-picking market, but unless they pick exactly these stocks, and pick exactly these stocks in large quantities, they’re not going to perform well anytime soon.

No amount of statistics from fund managers can change this cold hard fact.

Write to Jason Zweig at intelligentinvestor@wsj.com.