Why is it so hard to beat the market?
I’m pretty competitive. I grew up ski racing, and kept racing after college. I like the discipline and personal excellence that competition demands.
So it’s frustrating when I see the market move up more rapidly than my portfolio. I get buyer’s remorse: why didn’t I just buy the index and forget about it? This has been especially trying over the past five years. Except for a brief period in 2016, growth stocks have been doing better than value. And passive funds have been beating active managers – leading to an exodus from actively-managed mutual funds into passive index funds. Mutual fund giant Blackrock is following this trend, and Vanguard is receiving $2 billion per day.
A major reason for this has to do with skewness: the majority of the large-cap index’s returns come from a minority of stocks. In the US, 25% of stocks were responsible for 100% of the market’s gains. If you invested in the entire market – but missed those companies – your total return was zero from 1983 to 2006. The same is true for other markets. In Canada, 15% of stocks created gains; the UK market was dominated by 11% of companies.
This makes intuitive sense, especially among large-cap stocks. The market is driven by smaller firms that make it big and come to dominate the index. Over the past decade, the Big Five tech firms have come from relative obscurity to become market darlings: Facebook, Amazon, Apple, Google, and Microsoft. They now account for over 11% of the market – over $2.5 trillion. On average, they’ve risen 26% this year – far more than the market’s 9%. Without their contribution, the market would only be up 6%.
This makes it hard for traditional asset managers to beat the market right now. Unless we go outside our normal disciplines and overweight these growth darlings – devoting up to a fifth of our portfolios to some of the market’s most expensive stocks – it’s hard to show truly outstanding numbers. Their weighted average Price/Earnings Ratio is over 50.
But what goes around comes around. These companies enjoy near-monopolies in their respective areas: Facebook in social networking, Amazon in e-commerce, Apple in high-end phones, Google in search, and Microsoft in enterprise. Apart from the attention of the Justice Department’s anti-trust people, monopolies create a lot of their own problems: managerial fiefdoms, irrational incentives, an emphasis on empire-building, and savage M&A activities. You can’t repeal human nature.
The Big Five tech firms dominate the market now, but ten years ago it was GE, Exxon, Citigroup, Bank of America, and Apple. Fifty years ago it was GE, Standard Oil, DuPont, AT&T, and GM. Buying the market’s darlings may feel like you’re hitching your wagon to a star, but it can turn out to be a falling star. Nothing fails like success.
Skewness makes the market hard to beat in a bull run. But it works the other way, at other times and in other markets. In investing, what’s profitable rarely feels comfortable, and what’s comfortable rarely feels profitable.
Douglas R. Tengdin, CFA