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Why You're Not Beating the Market

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Politicians aren't the only ones facing fallout from angry Americans this fall. Investors are voting with their feet and leaving the stock market in droves. Actively managed mutual funds have been one of the primary victims of this flight from equity, with $191 billion pulled from equity funds in 2008 and 2009, according to Investment Company Institute data.

To add insult to injury, a majority of actively managed funds have trailed the market in recent years. Investors are rightfully asking why they should pay higher fees for active managers if they aren't going to beat the market. However, there may be a compelling reason why these funds are struggling as of late.

Losing their way
It's hard to argue that actively managed funds aren't having difficulty in this market. Since the beginning of 2008, the average large-growth fund has lost an annualized 10.4%, while the average large-value fund is down 10.6%, according to Morningstar data. In that same time, the S&P 500 Index has given up 9.8%. Investors have been understandably disappointed. After all, shouldn't active managers have been smart enough to see the financial crisis coming and protect their portfolios accordingly?

But while results have been disappointing, we may not be able to hang all of the blame on active fund managers' lack of skill. Correlations among asset classes skyrocketed during the crisis, making it harder for managers to pick investments that outperform. Correlation, which measures how assets move with respect to one another, jumped in 2008 because nearly all stocks and other asset classes plunged during the credit crisis. Correlations remained high as the majority of asset classes rebounded in tandem in 2009, which means that few stocks have been able to escape the directional pull of the broader market in recent years.

Even during 2010, correlation has continued to remain elevated. Research and investment firm Birinyi Associates took a sample of 50 trading days from April to July and found the correlation between the U.S. equity benchmark and its underlying individual-stock holdings was 0.81, almost twice the historical average of 0.45 over the past 30 years. Such an environment surely won't last forever, but while it does, it will make picking winning stocks that much harder.

Stuck in the middle
In a market environment where stocks are moving pretty much in lockstep, actively managed mutual funds have a much more difficult time beating the market. In fact, six of the 10 biggest mutual funds in existence have correlations of 0.99 with the market this year, meaning they have moved almost in lockstep with the broader market.

For example, American Funds Growth Fund of America (AGTHX), the second-largest fund around, is no index-hugger. The fund looks for companies with top-tier long-term growth prospects and is roughly 29% overweight to the information technology sector, compared with the S&P 500. Even though blue-chip tech holdings Microsoft (Nasdaq: MSFT  ) and Google (Nasdaq: GOOG  ) have lost ground over the past three years, they've still beaten the S&P 500 by a wide margin. Moreover, the fund found outperformers Oracle (Nasdaq: ORCL  ) and Apple (Nasdaq: AAPL  ) . But even with these top holdings meaningfully outperforming the broader market, the fund still has a 0.97 correlation to the S&P 500 over the past three years. This fund is actually beating the market over that time, but many other funds haven't been so lucky.

This phenomenon isn't limited to domestic stocks. American Funds Europacific Growth (AEPGX), the largest foreign stock fund around, clocks in with a 0.98 correlation to the MSCI EAFE Index over the past three years. Yet it has made highly successful picks, including America Movil (NYSE: AMX  ) , Novartis (NYSE: NVS  ) , and Anheuser-Busch InBev (NYSE: BUD  ) . Each of these names has drastically outperformed the MSCI EAFE Index in the past three years, yet the fund has still tracked that benchmark incredibly closely in that time.

It's true that it is more difficult for larger funds like these to move in a vastly different direction from their benchmarks. But these recent correlation numbers indicate that such a task has become increasingly difficult even for accomplished managers.

A light at the end of the tunnel
While it may be frustrating to be a mutual fund investor right now, the important thing to remember is that this period of high asset correlation won't stick around forever. We all know investors have a habit of moving into and out of investments at exactly the wrong time. Just as folks who are loading up on bonds right now are likely doing so at the worst possible moment, so too are investors shunning actively managed funds at an inopportune moment. True, most of these funds haven't had much to show for themselves lately, but as the financial markets settle back down from their crisis levels and asset correlations begin to decouple, smart stock pickers will once again have the upper hand.

That means that picking the right managers and the right funds will become vitally important in the coming years. At the Fool's Rule Your Retirement service, we pick through the thousands of funds on the market and identify those winning investments that are most likely to make money over the long run. Our proven fund selection criteria include looking for funds with long-tenured managers, a consistent investment process, low expenses, and long-term outperformance in both good and bad market environments. Any fund you buy should measure up on those fronts, at a bare minimum. 

If you've been frustrated with your actively managed funds, don't give up just yet. Keep your focus on the long run, and if you've got solid, well-managed funds, don't throw them away because an extremely difficult market environment has handicapped a lot of good managers. Those with super stock-picking skills should have their day in the sun again, and investors who stay the course should be able to profit handsomely.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

 Amanda Kish is the Fool's resident fund advisor for Rule Your Retirement. You can start your free 30-day trial today to the service today.At the time of publication, she did not own any of the funds or companies mentioned herein. Microsoft and Google are Motley Fool Inside Value recommendations. Google is a Rule Breakers selection. Morningstar and Apple are Stock Advisor recommendations. Novartis and America Movil are Global Gains selections. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Microsoft, Google, and Oracle. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (3)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 16, 2010, at 8:13 PM, gerrythek wrote:

    Interesting. I decided to see how the two large-cap mutual funds that I own compare. These two funds are YACKX and FAIRX.

    Right away I see that Ms. Kish's numbers don't add up. The S&P 500 closed on 12/31/07 at 1468.36. This is the number that should be used if one talks about "the beginning of 2008". Since the index closed at 1124.66 today, that represents a drop of 23.4%. Quite different than the -9.8% quoted above.

    By the way, while the S&P 500 was losing 23.4%, YACKX and FAIRX were gaining 23.2% and 5.8% respectively. It just proves that one has to choose the right no-load actively managed fund.

  • Report this Comment On September 16, 2010, at 8:39 PM, ilovesumm wrote:

    Its been widely discussed before that > 70% of mutals and professional investors don't beat the index so your odds are you will underperform the market.

  • Report this Comment On September 17, 2010, at 4:47 PM, FriedBrain wrote:

    @gerrythek: the reason the author's numbers "don't add up" is because they're annualized numbers, and not absolute returns. The use of annualized returns was stated when providing the first return rate, and thus implied for the others.

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Amanda Kish
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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter.

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