Charles Dickens once wrote "it was the best of times, it was the worst of times." Nothing could better describe the state of the mutual fund business.
The stock market, as measured by the Standard & Poor's 500 stock index, has rewarded investors with an average return of 48% a year during the past 10 years. The stock market has never been so rewarding for any 10-year period in history.
But many investors have been disappointed by the vast majority of stock funds underperforming the S&P 500.
The Lipper Survey of Mutual Funds reports an astounding 92% of equity mutual funds have failed to keep pace with the S&P 500 in the past 10 years. Not a single mutual fund among the top 25 in assets has managed to beat the S&P 500 in the past five years.
Clearly, those numbers add up to the worst relative performance in history. Are fund managers really this bad?
How bad are they?
In searching for an answer to this question, I went to a small-capitalization stock fund study compiled many years ago using the Wiesenberger Investment Company Survey, which offers the longest history on mutual fund performance. There are two distinct periods of performance in the 43-year comparison of small-cap funds against the S&P 500. During 1955-'82, the funds outperformed the S&P 500 in 18 of 27 years, or 67% of the time. This was somewhat better than the norm of 60% compiled over a 65-year period, according to a study on small stocks compiled by Dimensional Fund Advisors.
The cumulative return for small-cap funds was more than double the S&P 500 return for the period, 18,544% vs. 7,670%. Of course the S&P 500 return is overstated; it does not reflect management fees or transaction costs arising from periodic changes in the components of the index.
A huge change took place in the stock market starting in 1983: Big stocks wrestled leadership from small stocks. The pattern of small stocks doing better than the S&P 500, which had been established for nearly three decades, was broken, and with it the superior performance by active managers. Small-cap funds underperformed the S&P 500 in 12 of the next 16 years with a cumulative return that was about 40% of the S&P 500 return during 1983-98, 520% vs. 1,338%.
General equity mutual funds encountered similar headwinds by underperforming in 13 of 16 years through 1998.
Small-cap advantage
The performance pendulum had swung in the opposite direction with a vengeance. Despite the bleak relative performance numbers recorded during this 16-year period, small-cap funds still owned a sizable performance advantage over the S&P 500 that was worth almost 20% more in actual dollars over the full 43-year span.
Since the change 16 years ago, the vast majority of funds haven't been able to keep pace with the market averages. Four factors contributed.
The two dominant factors in the pendulum's swing are the globalization of the U.S. economy and the prodigious growth in mutual fund assets. Two lesser factors, which further abetted big stocks, were related to an explosion of merger and acquisition activities and a major move to indexing in the stock market.
In the 1970s, American companies started to change because of pressure by worldwide competition. For years market share had been the main focus of American companies, to the detriment of profits.
Suddenly, when the focus was redirected toward profitability, loss-producing or marginally profitable businesses were jettisoned and excessive layers of management were shed in the quest for higher profits.
Companies made major investments in new plants and equipment to boost productivity and moved manufacturing outside the country to gain a cost advantage. Outsourcing of manufacturing activities also became another way to lower costs and become more efficient. From 1982-'98, corporate profits surged more than three-fold. However, big companies' profits literally went through the roof as Dow Jones industrial average earnings exploded to $395 from $9 per share. Big companies' profits grew 14 times faster than overall corporate profits during the period.
Savings binge
It has long been publicized that most Americans have not saved enough for retirement and that the Social Security Administration will run out of money to pay benefits. Increased awareness of these issues has led to the greatest savings binge in history, accompanied by an unprecedented accumulation of mutual fund assets by individuals and retirement plans.
In turn, the mammoth flow of funds into equity mutual funds has helped to fuel one of the most powerful bull markets on record. Net assets of equity mutual funds were only $54 billion in 1982. By 1998, net assets of stock funds had ballooned to approximately $3 trillion, for a 55-fold gain in just 16 years. To put this into perspective, the gross domestic product grew three-fold over the same time span. In 1982, stock fund assets represented 2% of GDP; the percentage grew to 39% of GDP by 1998. Most of this money had to be put to work quickly, and the quickest way was to invest in big stocks.
Efficiency moves
The 1980s and '90s saw inflation ratcheting down in the United States, making it tough for many companies to raise prices and improve profitability. Once the limits of efficiency were reached internally, many companies started to look outside their domain to improve profitability, which gave rise to an explosion of mergers and acquisitions. In some instances, less efficient companies were brought into the fold and made more efficient. In other instances, efficiencies were obtained by simply eliminating duplicate functions in the combined entities. From 1982-'98, mergers and acquisitions grew from a dollar volume of $64 billion to $1.7 trillion, with most of the consolidations taking place among big companies. Once again, the big stocks were the beneficiaries in the stock market, causing most funds to underperform.
Underperfomance started to take on a life of its own, becoming a self-fulfilling prophecy when most institutional investors were unable to beat the market for many years. "If you can't beat them, join them" became the rallying cry for most major institutional retirement plans. Indexed assets in the S&P 500 swelled to an estimated $925 billion in 1998 from $24 billion in 1982, increasing 39-fold in just 16 years, which exacerbated the performance dilemma.
Just as most fund managers will underperform when big stocks are driving the stock market, the big stocks in the market indexes will do better than the market averages. The last year in which mutual funds beat the S&P 500 on average was in 1993. From 1993-'98, the largest 20 stocks in the S&P 500 appreciated 263% before income, compared with an advance of 163% for the S&P 500. The largest 100 stocks in the NASDAQ composite appreciated 360% vs. 182% for the NASDAQ composite index. Most funds were left behind the S&P 500 in the wake of big stock dominance.
Globalization of U.S. companies, the push toward greater efficiencies, exponential growth in the assets of equity mutual funds, proliferation of mergers and acquisitions, and a powerful trend toward indexing have created an uneven playing field for equity mutual funds, reducing the probability of beating the stock market. Who would ever have thought that investors could win in the stock market by being average, and beat the preponderance of funds in the process? The past 10 years, in which nine of every 10 funds have underperformed the stock market, may well never be repeated again, but it has left a legacy. The long-term record of superior performance by mutual funds has given way to the impression in recent years that it is impossible to beat the stock market.
Robert Zuccaro is president of Target Investors Inc. and the Grand Prix Fund
