Since 1926, Entire Market Gain Is Due To Four Percent Best Performers

Why do active managers underperform broad-based stock indexes? Hendrik Bessembinder of Arizona State thinks he might have the answer. The vast majority of stocks have failed to outperform T-Bills, he points out in a study. It is only a small percentage of stocks that lead indexes higher. On a statistical basis, selecting individual issues means the odds are stacked against the stock picker from the start.

When Bessembinder looks at the title of his August 2017 study, “Do Stocks Outperform Treasury Bills?” he considers it “nonsensical.” After all, the fact that long-term stock market investments perform better than short-term, T-Bills has been extensively documented, he notes.

“The degree to which stock markets outperform is so large that there is wide-spread reference to the ‘equity premium puzzle,’” he wrote. The S&P 500, which traded near 250 just before the Great Depression, has doubled ten times over, generating nearly a 10% annual compounded growth rate. Compare this to a one-month T-Bills, with an average monthly rate of return of 0.37%, or 4.4% per year, and it seems obvious that stocks have returned more than T-Bills.

Specifically, the study states:

The 1,092 top-performing companies, slightly more than four percent of the total, account for all of the wealth creation.

But the major indexes, which are asset-weighted can be misleading.

Just four stocks – Apple, Microsoft, Amazon and Facebook – collectively make up more than 10% of the S&P 500 year to date. On an equal weighted basis, they represent less than 1%. Further, 40% of the value of the QQQ, market-cap-weighted index of 100 top Nasdaq-listed stocks, is attributed to these same four stocks.

Recognizing this, Bessembinder relied upon the Center for Research in Securities Prices (CRSP) monthly stock return database. This database has wide coverage, including all common stocks listed on the NYSE, Amex, and NASDAQ exchanges.

When this monthly stock database was reviewed and a thin fat right tail result was discovered. From 1926 to 2016, only 47.8% of individual stocks delivered returns are larger than the one-month T-Bills, with slightly more stocks negative than positive.

His research indicates that slightly more than four out of every seven common stocks in the CRSP database since 1926 have buy-and-hold returns, including reinvested dividends, less than those on one-month T-Bills.

The vast majority of stocks, 96%, are lackluster performers while “the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed companies,” he observed. “Very large positive returns to a few stocks offset the modest or negative returns to more typical stocks,” the report concluded, pointing to the importance of positive skewness.

(Click on image to enlarge)

(Click on image to enlarge)

There is also a survivorship bias issue. The report noted individual common stocks lasted, on average, seven and a half years in the CRSP database.

With the vast majority of stocks delivering muted, if not negative performance, to an extent it becomes a mathematical equation to explain why active managers have difficulty outperforming the broader indexes on a year in and year out basis. Putting active manager skill aside, the odds of selecting stocks that outperform “the market” is decidedly stacked against the investor.

To illustrate this point, Bessembinder conducted a random sample test. He selected investments in various single stocks and compared it to the benchmark index. He discovered that the single stock strategy underperformed the value-weighted index in 96% of the simulations, and underperformed the equal-weighed market 99% of the time.

“The results help to explain why active strategies, which tend to be poorly diversified, most often underperform market averages,” he concluded.

While he noted the difficulty of picking individual stocks and holding them for the long term, Bessembinder did point to specific timing issues that would have helped active managers. He pointed to research from Savor and Wilson (2013) that shows nearly 60% of cumulative stock market return premium accrues on days where macroeconomic announcements are made.