Llast year Plunging markets made few investors smile. Stocks and bonds fell simultaneously; Haven assets did not offer a safe haven. Doing well meant losing single-digit percentages instead of doubling them. It may therefore seem a strange time for fund managers to take a leap forward.
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But on Jan. 23, it emerged that Citadel, a secretive Miami-based investment firm, had generated $16 billion in net profits for its clients in 2022, breaking the record for the largest annual profit in dollar terms. His main hedge fund returned 38% — meanwhile msci‘s broadest index of global equities fell 18%. The champagne corks popped elsewhere too. Strategas Securities, a brokerage and research firm, estimates that 62% of active fund managers investing in large American companies own the s&p 500 index of such stocks in 2022, the highest percentage since 2005.
The past year therefore led to a miserable streak of bad luck for stock pickers. Each year from 2010 to 2021, more than half of active managers compared their performance against the benchmark s&p 500 couldn’t beat it. In other words, the average fund manager was outperformed by a simple algorithm that blindly bought every stock in the index. Such algorithms — known as “passive” or “index” funds — are taking the lead. As of 2021, they held 43% of the assets managed by American investment firms and owned a larger share of the country’s stock market than their actively managed counterparts.
The logic behind passive funds is inescapable. By definition, an index’s performance is the average of those who own the underlying stocks. Beating an index is a zero-sum game. If one investor does it, another must lose. Active managers can discover a superstar stock that ends up eclipsing all the others. But it will also be in the index, so passive investors will also buy it. Meanwhile, active managers tend to charge fees that are orders of magnitude higher than passive ones: often 1-2% per year and more for smart hedge funds, compared to just 0.03% for their algorithmic peers. This drag on performance makes it all but inevitable that index funds will outperform human money managers over the long term.
So how did fund managers outperform in 2022? One possibility is sheer luck. Randomly pick a group of stocks from an index, subtract a percentage point or two from their returns for fees, and occasionally you’ll have picked stocks that perform well enough to outperform the average.
A variation of this allows the stockpicker some dexterity. As of early 2022, Alphabet, Amazon, Apple, Microsoft, and Tesla accounted for almost a quarter of the total market cap s&p 500. Their collective value fell 38% over the year; the rest of the index fell just 15%. The index was so concentrated that a single good judgment – assuming that the stocks of American tech giants were foamy and should be avoided – would have given a stock picker a good chance of beating the market.
Extending this tech-fatigue to a more general concern about stock valuations would have given stock pickers a second chance to outperform. In the easy money years that followed the global financial crisis of 2007-09 and then Covid-19, arguing about such things was out of style. Share prices soared to staggering multiples of the earnings or assets of the underlying companies and then continued to soar. Those who took that as a signal to avoid them in anticipation of a correction lost. Passive funds that bought everything indiscriminately, including stocks that seemed overpriced, thrived. But in 2022, rising interest rates brought the trend to an abrupt halt. Investors who had been looking for stocks that were cheap relative to their fundamentals have finally been rewarded.
For companies like Citadel, falling stock and bond prices offered one last chance to prove their worth. Market crashes and an uncertain economic backdrop are the raison d’être for hedge funds with a mandate to invest in any asset class. Stock indexes that fall by double digits are a lot easier to beat when you’re not committed to buying stocks, as are the funds that track the market. And for the nimblest managers, last year’s crises looked like opportunities. When UK pension funds were forced into fire sales in September due to a convulsing government bond market, Apollo, a private investment firm, began buying up assets to make a quick profit. Index funds aren’t going away, and they shouldn’t go away. But only occasionally are active managers worth their fees.
Read more from Buttonwood, our financial markets columnist:
Venture Capital’s $300 Billion Question (January 18)
The dollar could be in for a nasty surprise for investors (January 12)
Will 2023 be another terrible year for investors? (January 5th)
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