Investors, it's not your fault you underperform

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters

A new report should put active managers out there at ease. It makes the case that intellect is not at fault for their chronic underperformance against the S&P 500.

It's the S&P 500's fault.

"In this note we offer investors a break some may need—they are being compared to a moving target, and that target is hard to beat," wrote Adam Parker and his strategy team at Morgan Stanley in a report titled, "Why Is Active Management So Difficult?"

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Active managers could use the empathy. Less than a third of equity mutual fund managers beat their benchmarks over the past decade, according to Morningstar.

The reason why the S&P 500 is a difficult index to top is because turnover is very high, working against long-term managers' strategy to hold stocks for several years.

States the report:

"Ten percent of the companies in today's index are different since 2011, 17 percent are different since 2009, and fully half the companies are different since 1999. Said another way, at least half the companies in the S&P 500 today were not in the S&P 500 when your average portfolio manager started running a portfolio."

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When stocks are removed because of a takeover or significant price drop, they are replaced by companies with much faster earnings and revenue growth. That too artificially favors managers with a growth focus and works against value managers who may hold onto stocks with underperforming fundamentals.

"Quite naturally then, with faster prior revenue and earnings growth, and higher margins, the stocks added to the index typically have performed much better over the few years before their inclusion. This would indicate that the new stocks have very good price momentum relative to the existing or removed stocks. In fact, on average, stocks added to the S&P 500 have outperformed those in the index or those removed by more than 10 percent per year over the last five years."

What's more, when an addition is made by the index committee at Standard & Poor's a totally different stock from a different sector than the old member is added, hurting fund managers not allocated enough to that specific industry, contends Parker.

"This bias to higher growth stocks has led to a dramatic shift in the sectoral composition of the index. The fraction of S&P 500 stocks in health care has almost doubled in the last 20 years, from 6 percent in 1994 to 11 percent by the end of 2014."

Some investors have a lack of sympathy for their peers, making the case that the weak performance by active managers is for much different reasons.

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"The real reason active management fell off the cliff last year is that there are fewer suckers in the market. As mom and pop adopt passive strategies, there are fewer mistakes being made by amateurs trading stocks which skilled pros used to be very good at harvesting," said Josh Brown, CEO of Ritholtz Wealth Management and author of The Reformed Broker blog.

Regardless of the reason, Parker has some advice for those looking to up their game against the benchmark.

"One possibility is to avoid S&P 500 companies that have slowing growth, low margins and poor price momentum," he wrote.

If only it were that easy.