Conditions are ripe this year for mutual fund managers to outperform the market after years of lagging behind it. However, even a near-perfect environment may not be enough for them.
The good news for the $13.9 trillion mutual fund industry is that 2017 has started off fairly well. About half the large-cap funds have outperformed the market as measured against the Russell 1000 so far, according to a Goldman Sachs analysis. That compares with just a paltry 19 percent beat rate in 2016.
The improvement comes amid multiyear lows in the tendency of stocks to correlate up and down together, as well as an elevated level of dispersion, or the difference between returns for various sectors. Stock pickers in actively managed mutual funds rely on both trends to provide opportunities to beat market indexes.
Large-cap core funds returned 5.6 percent through the first seven weeks or so of the year, with 37 percent beating the S&P 500, above the 10-year average of 34 percent.
Source: FactSet, Lipper, Goldman Sachs Global Investment Research
But here's the bad news: Judging by current positioning, the likelihood that outperformance will carry through the year is low, Goldman said in a report for clients. The crux of the argument, laid out by chief U.S. equity strategist David Kostin, is this:
We expect higher stock return dispersion in 2017 vs. 2016, which should improve the stock picking environment for fundamental investors.
However, mutual fund managers are not positioned to capitalize on the opportunity. Funds allocate their largest active share to the stocks least likely to generate alpha. Mutual funds hold index weights in stocks that are more likely to generate alpha under our dispersion framework.
"Alpha" is the market term for beating benchmark indexes. For fund managers, the critical way to beat benchmarks is by holding more outperforming stocks above the weight that they take up in benchmark indexes and to hold an underweight level of lower-performing stocks.