‘Tis The Season…

Summary: As we close in on year-end, active stock managers in the U.S. have defended their year-to-date under-performance against the S&P 500 by claiming that returns have “consolidated” among a few Mega-Cap (very large) companies. We examine this claim and find it to be untrue and wonder why managers didn’t find opportunity in the 200+ stocks in the S&P 500 that have outperformed.

We care about this topic because we are sometimes weary of an industry that repeatedly projects itself against the performance of narrow indexes. We feel that a fatal error for those trying to reach a financial goal is trying to chase benchmarks.  So why do they try?  Because that is the way the traditional wealth management business has practiced.

Tis the Season…for fudging

As we close in on the end of the year we begin to reckon with how we have done, both as managers and the industry as a whole. We have been reading commentaries from mutual fund managers we work with.

One recurring theme among stock managers and commentators this year is that stocks have “consolidated”. That is to say,  returns of the S&P 500 are increasingly driven by a small number of ‘mega-cap’ stocks. This is often taken further as “if a manager didn’t own enough Apple (or other mega-cap stock) they could not do well”. What does this mean and, more importantly, is it a real defense of under-performance? See, managers can get really detailed when discussing the ways in which they managed to lag a benchmark. This is, in our view, a great reason to think a whole lot less about benchmarks and a whole lot more about the amount of risk taken to earn returns and keep one’s focus on progress toward a long-term plan.

So what does this mean – consolidation into a few mega-caps? Stocks are sorted by their size, measured by the total number of shares outstanding multiplied by the price of a share. In this way a very large company, such as Apple or IBM or Exxon will have a very large “market cap” – measured in the hundreds of billions of dollars. This is known as “market capitalization”, “market cap” or “cap” for short, which is shorthand for the size of the company. Market cap groups break down like this:

Mega-Cap: greater than $200 billion market cap
Large-Cap: $10 billion to $200 billion
Mid-Cap: $2 billion to $10 billion
Small-Cap: $300 million to $2 billion
Micro-Cap: Any public company less than $300 million.

You will notice that most of the companies are likely to fall in the “large cap” category. So, exposure to this group will cover most of the S&P 500, which is the broadest index of U.S. stocks. How does the S&P 500 break down? As of October 31, 2014:

Mega-Cap: 14 companies, or 2.8%
Large-Cap: 362 companies or 72.3%
Mid Cap: 125 companies or 25%
(Note: these are the holdings of the Vanguard S&P 500 index fund)

So if the returns of the index are concentrated in only 14 stocks, that is a tough situation – how to know which to own? That is a tall order. But we watch returns on a pretty sizable block of stocks, mostly not-mega caps, and this consolidation story felt a little fishy. So we did what we always do at KH and took a look for ourselves.

Using the holdings of the Vanguard S&P 500 index fund, we asked the following questions:

  1. How much of the return of the S&P 500 year to date is due to the small group of Mega-Cap stocks?
  2. What is the average return of the mega-cap stocks vs. the return of the S&P 5oo year to date?
  3. If a manager were to be so bold as to own more than the 14 stocks “driving the return of the whole index”, would she find opportunities?
  4. How many non Mega-cap stocks in the S&P 500 beat the index year to date, meaning how many non Mega-Cap chances were there to outperform the index?

What did we find? Well, it turns out that fudge and fudging don’t just happen in our kitchens around the holidays…

  1. Of the S&P 500’s 11% return year to date about one quarter of that is explained by Mega-Cap stocks – certainly out of proportion to their contribution as only 2.8% of the index.
  2. The average return of all the Mega-Caps was 10.7%. Hmm, that seems funny. On average Mega-Caps aren’t really beating the index at all. To be sure there are some big returns: Apple has returned 37%, Microsoft 28%, Johnson & Johnson 20%. And it’s true, a small group of Mega-Caps – six to be exact – have beaten the S&P 500. Picking those out of 500 would be tough, but does that mean that stocks are consolidating into a few Mega-Caps?  We had to ask another question: were there opportunities for a manager to shop elsewhere?
  3. Uh-oh… The average return of Large-Cap stocks ($20-$200B) was a healthy 12% – ahead of the index’s 11%. But was it “consolidated”?
  4. We counted the number of Large-Caps that beat the S&P 500 year to date and found 163! How about Mid-Caps? 53! That means that instead of fighting the rest of the world for 14 stocks, a manager who chose to roam in the entire S&P 500 could have found 216 stocks – 43% of the index – that would do better.

What did we learn here and why are we sharing this?

Investors and clients should always be on the lookout for defenses of under-performance. Standard & Poors reports twice a year on how active managers did versus benchmarks and the results are witheringly bad, year in year out. I have only read from managers that returns were “consolidated” this year, a year when managers have done especially bad – about 85% of managers trying to beat the S&P 500 had failed through October. That generally means, actually, that a few sleepy old Mega-Cap companies have done surprisingly well and managers were caught flat footed. That’s a fair error – waking up and expecting a 28% return out of Microsoft after it returned 44% last year requires a good bit of open-mindedness and prescience. But the real question is the next one.

Why do managers care about these Mega-Caps at all? If there are literally hundreds of other companies to choose from, why look at the largest, most studied ones? The companies where a manager is least-likely to have any sort of informational advantage? We have to conclude, at least in part, that it is fear of herding and also what is known as “closet indexing”. Better to fail with the herd than break free and risk it.

Nobody is perfect – we hire managers to do things we know they won’t always do. But we do try to free them, or find ones who have freed themselves, from the problem of benchmarks. It can be a disorienting experience. We believe the most important factor is not the industry shell game of chasing benchmarks. Instead, it is using stocks and bonds and other liquid assets to generate risk adjusted returns that are superior to the experience of just owning a benchmark. Owning a globally diversified portfolio that is managed with a robust risk management process is an integral part of planning one’s financial life.

Year-to-date stock returns in the S&P 500 have not consolidated into a few stocks. That does not appear to be true.

Let’s keep the fudging in the kitchen; managers should stop fudging the truth.