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Awful mutual funds actually have put together two pretty good months

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

Mutual fund performance has been improving lately, during what has been a mostly awful year.

Just 16 percent of large-cap mutual funds have outperformed basic market benchmarks so far in 2016 — a rate approaching historically bad levels for performance and well below the 10-year average of 37 percent, according to Goldman Sachs calculations.

The struggles of stock pickers have been well-documented. Active managers have struggled in an era that's known for how the prices of individual stocks move up and down together — what is usually referred to as "correlation" — as well as comparatively little difference in performance between individual sectors, which market pros call "dispersion."

The culprit has been high levels of central bank intervention, which has tamped down volatility and made it more difficult to find price disparities between individual stocks, and thus opportunity to outperform the market.

However, the pendulum has begun to swing lately.

About 60 percent of mutual funds have beaten benchmarks so far in the third quarter, according to Goldman, which bases its performance tracking on a sample of 435 funds with $1.5 trillion in assets. There are 7,671 mutual funds in all — including 4,783 that are equity-based — with total assets of $13.6 trillion, according to the Investment Company Institute.

The performance comes after about 58 percent beat benchmarks in July.

The reason for the shift is fairly simple: Managers had been getting beaten up by crowd-following, with the most popular stocks in terms of portfolio weight significantly underperforming the least-loved batch.

From January 2015 through the first six months of 2016, a basket of stocks that Goldman compiled representing the most overweight positions in mutual funds underperformed the S&P 500 by 10 percentage points. Conversely, the most underweighted stocks outperformed the index by 9 percentage points.

Since then, though, the script has flipped. Overweighted stocks have outperformed by 1.5 percentage points, while the underweight basket is off the mark by 4 percentage points.

Another factor has been the shift from defensive to cyclical stocks, which Goldman warned may not last.

"Low GDP growth and uncertain Fed policy pose risks to cyclical outperformance through year-end," David Kostin, Goldman's chief U.S. equity strategist, said in the report.

The underperformance has spread throughout the mutual fund universe.

Just 22 percent of large-cap core funds have beaten the S&P 500 this year; large-cap growth is at just a 9 percent beat rate while large-cap value is at a 17 percent beat rate.

The trend has driven investor behavior, with money pouring out of actively managed funds and into passively managed exchange-traded funds that track indexes and have much lower fees. ETF assets are at $2.3 trillion, up 11 percent from a year ago.

Over the past year, investors have pulled $303.4 billion from active funds while pumping $437.3 billion into passive, according to Morningstar.

Correction: About 60 percent of mutual funds have beaten benchmarks so far in the third quarter, according to Goldman. An earlier version misstated the period.