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Debunking Wall Street's 'window dressing' theory

Traders work on the floor of the New York Stock Exchange in New York.
Jin Lee | Bloomberg | Getty Images
Traders work on the floor of the New York Stock Exchange in New York.

Stockpickers have had a miserable year, so the natural tendency is to expect that they'll be playing catch-up aggressively through the end of the year—a bullish case for the stock market.

That's not necessarily the case, though.

In fact, the sledding could get even tougher for active portfolio managers, particularly if the stock market finishes strongly in 2014, according to a Bank of America Merrill Lynch report.

BofAML actually believes the market is going to be OK through the remainder of the year, but not because managers suddenly will get better about which stocks or mutual funds they select.

"Sentiment is bearish, cash balances are high and valuations are not stretched," Savita Subramanian, the firm's equity and quant strategist, said in a note to clients. "But we find scant evidence for the bull case that active funds' underperformance could spawn a year-end catch up rally."

That sentiment runs contrary to many of the opinions being bandied about Wall Street, where only about 1 in 5 active managers are beating their benchmarks.

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Goldman Sachs, for one, is basing its year-end S&P 500 forecast of 2,050 in part on active managers stuffing their portfolios with winners—"window dressing," in Street parlance—in order to catch up to performance.

"We believe the S&P 500 will rise by 2 percent through year-end as funds will be compelled to add exposure in an attempt to boost returns before year-end," Goldman strategist Amanda Sneider and others said in a note. "Since 1991, the nine times when fewer than 40 percent of large-cap core mutual funds were beating the S&P 500 at the end of (the third quarter), the index has averaged a (fourth-quarter) return nearly 200 (basis points, or 2.0 percentage points) higher than in times when more funds were outperforming."

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Subramanian, though, said the going gets tougher for active management in years when market performance is strong.

"Years during which hedge funds underperformed the S&P 500 by the end of August saw median September to December returns of 10 percent, versus median performance of 6 percent overall," she said. "Statistics for mutual funds are similar. But the relationship is not causal. Active funds have a greater tendency to lag during strong equity markets—the hurdle is higher. And strong starts to the year tend to have strong finishes."

In the BofA forecast, the market is about to undergo some volatility from which it will recover and rally into year's end. Subramanian said data show little correlation between active fund performance and stock market returns.

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"Some of the years with weak year-end returns (1994, 2012) saw active strategies generally underwater heading into September," she said. "Banking on a catch-up rally may be risky."

—By CNBC's Jeff Cox