Active Large Cap Hot Streak Doesn’t Add Up

Active Large Cap Hot Streak Doesn’t Add Up

Recent claims of active equity outperformance are overblown.

Reviewed by: Allan Roth
Edited by: Allan Roth

I was recently struck by a Bloomberg article on the hot streak of active, large-cap U.S. stock mutual funds. Barron’s had a similar article claiming active stock pickers had a big July. Both articles cite a Bank of America Merrill Lynch research paper claiming:

  • Active U.S. large-cap funds outperformed the appropriate index in six of the last seven months this year.
  • Managers’ success has been due to a stock picker’s market where “pair-wise correlation of S&P 500 stocks” is at a 17-year low.
  • Managers benefited from a record overweight in tech and bias toward “low-quality stocks.”

Is it now a stock picker’s market? According to William Sharpe’s paper, “Arithmetic of Active Management,” this claim is unlikely to be true. Sharpe states:

“Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

So I requested a copy of the not-publicly available Merrill Lynch research paper, “US Mutual Fund Performance Update: Record Outperformance Streak.” I also interviewed one of its authors, Jill Carey Hall, VP of U.S. Equity Strategy team at Bank of America Merrill Lynch. The paper showed that February was the only month where less than half of the funds bested their benchmark. 




What Was Different In February

In discussing the methodology with Hall, she stated the paper compared the performance of large-cap U.S. stock funds to the appropriate total return of the Russell 1000, Russell 1000 Growth, and Russell 1000 Value indexes. I asked what was different about February, the outlier month? I pointed out that tech outperformed large-cap that month as well.

She stated, “Even though tech did well, consumer discretionary (the other of their big overweights) underperformed in February, and some sectors managers were underweight did well (real estate, utilities).”

I tested out yet another theory on her. Before the call, I looked at what was different about both February and the last several years versus the six months where active bested passive. I found that international stocks significantly underperformed the U.S. What does this have to do with U.S. large-cap stock funds? Plenty.

According to Morningstar, the average active U.S. large-cap stock fund holds 7.98% international stocks. International stocks outperformed the U.S. stock market by 7.2 percentage points through July of this year, but underperformed by 2.5 percentage points in February, and badly underperformed most of the past five years.

In fact, a simple linear regression indicated that 62% of the monthly variation could be explained by how international stocks performed versus U.S. stocks. 




Using Assets Not In Benchmark

I asked Hall to comment on my hypothesis. She declined to comment, stating she had not looked at this data. So I directed it to David Blanchett, head of retirement research for Morningstar Investment Management, who responded:

“Large-cap U.S. stock mangers tend to also have other asset classes, such as international stock and cash. That some group of active managers collectively outperforms just means they’re investing in some other style not being captured by the index they are being benchmarked against.”

My take: Admittedly, this high correlation between active outperformance and international relative performance to U.S. stocks does not prove causality. Sharpe’s arithmetic is only true for active as a whole, while active mutual funds are merely a subset of total active U.S. large-cap stock market.

But mutual funds represent a very large percentage of ownership in U.S. stocks, and the performance of other ownership, such as hedge funds, may be even worse.

I’m with Sharpe in that it doesn’t matter one iota whether the market goes up or down or how high or low the “pairwise correlation” of stocks are. It doesn’t even matter what percentage of a market is passive. Active will best passive only when arithmetic stops working. And we all live in Lake Wobegon where the majority of active managers are above average.

Thus the active/passive debate continues—not because it’s a debatable issue but rather because active managers need the debate to continue. To stem the tide of money flowing from active to passive, these research papers will also continue. Index funds will be called evil and passive investing will be called worse than Marxism. Don’t buy into it.

At the time of writing, the author held stock in BAC. Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter


Allan Roth is founder of Wealth Logic, an hourly based financial planning and investment advisory firm. He also benchmarks portfolio performance for foundations and other business concerns. Roth's website is You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter