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Every year around this time, my wife and I take our two daughters to the local pumpkin patch in search of a few future jack-o’-lanterns.  Our first stop is always the Louisburg Cider Mill, where you’ll find the best apple cider donuts anywhere.  Then it’s out to the Powell Pumpkin Patch, complete with hayrides and a full-blown corn maze.  On this year’s trip, we were blessed with a picture-perfect fall day and the gourds were plentiful…

Not too long ago, I actually came across an article comparing the stock market to a pumpkin patch and active fund managers to pumpkin pickers:

“When active managers select stocks for a fund, they are essentially foraging for companies that will make good investments. If the stock market were a pumpkin patch, they’d be using the best pumpkin-picking strategy they know. This would be different from the strategies of other pumpkin-pickers, whose strategies in turn would be different from the next ones’. In other words, every fund manager has a unique approach to searching for the best investments available.”

As I watched dozens of kids with wheelbarrows race around the pumpkin patch in search of the perfect pumpkins, I couldn’t help but think back to this analogy.  My younger daughter employed the strategy of crossing a large pool of muddy water, figuring other kids weren’t quite as daring and better pumpkins could be had on the other side.  My older daughter was extremely discerning with every pumpkin, closely inspecting for any imperfections.  Overall, I’ve got to tell you, kids are pretty darn efficient at finding the best pumpkins.  The smaller, discolored, imperfect, smashed pumpkins get left behind.

Like pumpkin-picking kids, every active fund manager pursues the best stock-picking strategy they know in search of bountiful returns.  And, just like the kids, they’re pretty good at it.  If dozens of kids can sprint through a pumpkin patch and quickly find the biggest, orangest, most perfect pumpkins, think about what thousands of well-connected fund managers, with MBAs from Harvard or Wharton, can do when sifting through stocks.  They know what they’re doing.  But therein lies the problem.

Last week, S&P Dow Jones Indices released their SPIVA U.S. Mid-Year 2018 Scorecard showing the performance of actively managed stock funds relative to their benchmarks.  Over the past 15 years, it’s been a Halloween horror show with 92%+ of large-cap managers, 95%+ of mid-cap managers, and 97%+ of small-cap managers underperforming!

Between the stiff competition and having to overcome the higher fees they charge, active managers have a difficult time finding and maintaining an edge over the benchmarks.  Due to this frightening underperformance, investors have realized the trick with actively managed funds and discovered the treat of index funds and ETFs.  According to Bloomberg’s Eric Balchunas, through September, investors pulled $95 billion from active mutual funds, while pouring $330 billion into index mutual funds and ETFs.  Speaking of index mutual funds and ETFs (which track the same benchmarks active managers underperform), in the article comparing the stock market to a pumpkin patch, the pumpkin analogy continued:

“The most well-known indexes are weighted based on the size – i.e., the market capitalization – of the companies within. That includes the most commonly tracked index, the S&P 500, which is essentially a collection of the 500 largest publicly traded U.S. companies as measured by market cap (some exceptions apply). The largest companies, then, receive the most investment when money flows into passive investments. That money acts like water on the pumpkin patch. Every time money flows from active to passive management, it’s as though water is flowing to the biggest pumpkins (i.e., holdings) by virtue of their size. And then, as a consequence of the new money, the big get bigger.”

The attempted point here was that indexing is somehow distorting stock prices since money blindly flows to the largest companies, thereby causing stock prices to artificially inflate.  Lost in that is the fact that it’s active managers who, using their best stock picking strategies, set the prices of stocks relative to one another.  If active managers think Amazon is worth 80 times more than Macy’s, then index funds simply reflect that, proportionately buying stocks based on these relative prices active managers set.  If everyone, including active managers and index fund investors, just want to buy stocks – guess what?  Stock prices go up.  All the pumpkins get bigger.  There’s no magic here.  Ironically, while many active managers attempt to sell their ability to find the “Great Pumpkin” with their “unique” stock picking strategies, they usually end up owning the same big “pumpkins” as index funds and ETFs.  Checkout the top holdings of any large cap U.S. stock mutual fund and you’ll likely find most, if not all, of these names:

Why is it that active managers end up holding many of the same large and successful stocks as index funds and ETFs?  Because, again, they’re pretty smart.  Over time, the stock market has a way of naturally pruning the losers, leaving the winners to generate the bulk of investor returns.  Active managers want winners in their portfolios.  Consider research from Arizona State University finance professor Hendrik Bessembinder which found:

“The entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks.”

You read that right.  The best performing 4% of stocks made up the entire gain of the stock market over the past nearly 100 years!  If active managers miss out on holding that 4%, that becomes a significant problem.  As it turns out, pumpkin farmers and gardeners are probably least surprised by this.  According to the Farmer’s Almanac:

“Gardeners who are looking for a “prize for size” pumpkin might select the two or three prime candidates and remove all other fruit and vines.”

In other words, to grow the biggest and best pumpkins, the smaller and less healthy pumpkins are weeded out.  This is exactly what happens in the stock market.  The biggest and best companies tend to get bigger.  Smaller, unhealthy companies wither on the vine.  This is normal and logical.  There is nothing unusual about indexing and what’s occurring in the stock market right now.  As a matter of fact, the five largest “pumpkins” represent a smaller chunk of the S&P 500 than back in the 1960s & 70s.

Source:  Michael Batnik

 

We can debate whether other strategies provide more value than market cap weighted indexes, but we can’t ignore the fact that 4% of companies have generated all of the returns since 1926.  In the Halloween classic, “It’s the Great Pumpkin, Charlie Brown”, Linus is waiting for the Great Pumpkin to show up.  He believes the Great Pumpkin will deliver toys to all the good little girls and boys.  I can’t help but think of promises active managers make to investors, that they will deliver outsized returns.  If you’re waiting for the Great Pumpkin, you’ll likely end up like Linus…