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Why mutual funds could be on their way to another lousy year

Pedestrians walk along Wall Street near the New York Stock Exchange.
Michael Nagle | Bloomberg | Getty Images
Pedestrians walk along Wall Street near the New York Stock Exchange.

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.

Goldman contends that funds are holding too much of stocks that are least expected to generate alpha. In that basket are companies like Google parent Alphabet, Visa and UnitedHealth Group.

The firm believes funds should hold more shares of companies like Wynn Resorts, Nvidia and Seagate Technology, which are most expected to generate alpha but show up too seldom in fund holdings.

Mutual funds deviate from their benchmarks in stocks that we believe are unlikely to contribute to alpha generation, while they hold index weights in stocks that are more likely to generate alpha under our dispersion framework.

A passion for passive

Beating the returns of basic indexes like the Russell 1000, S&P 500 and Nasdaq has become critical for fund managers as hundreds of billions in investor cash has flocked to passive funds that track indexes. Passive investing, most often done through exchange-traded funds, generally carries far lower fees than active mutual funds.

The trend toward passive investing has accelerated as managers struggle to provide better-than-market returns.

ETF assets have risen by 174 percent over the past five years against growth of 74 percent for mutual funds, according to Goldman. In total assets, ETFs, with $2.6 trillion in total assets, still trail mutual funds by a lot but are gaining rapidly.

Mutual funds have suffered more outflows this year, though Goldman projects the total loss for the year to be $85 billion, which would be less than the $130 billion in redemptions last year.

To generate alpha, active managers have turned heavily to financial stocks — meaning banks and insurance companies — with a 17.3 percent allocation in the mutual fund sample Goldman examined.

Energy joined financials as a sector where managers increased exposure most, with information technology, consumer discretionary and health care the sectors that saw the biggest cut in allocations.