Why Picking Top Stocks Is Not Enough

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

The odds of picking winning stocks are often stacked against amateur investors. Even professionals, including many active fund managers, who have access to lots of data and teams of analysts, struggle to beat their indexes. A Morningstar researcher investigated how often professional money managers succeeded and whether their stock-picking success, or lack thereof, could help investors find better funds. Jack Shannon is a senior manager research analyst for Morningstar Research Services. Here’s our conversation.

Welcome back, Jack.

Jack Shannon: Thank you. It’s always a pleasure to be here.

Are Fund Managers Good at Making Big Stock Bets?

Hampton: Well, let’s get started. You did follow-up research on your Big Stock Bets report that was featured on the podcast in January. Can you talk briefly about the original research and why you wanted to go deeper?

Shannon: The original research was about whether big bets in portfolios, so big single positions, end up helping or hurting portfolio outcomes. And so, what I did was I collected years’ worth of data on these big positions and said, “In the aggregate, have they helped or hurt funds outperform the index?” And what I found was, for the most part, the bets were on winning stock. So, it was like two thirds of the bets ended up outperforming the market, yet less than a third of the funds actually outperformed the market. So, that raised the question of, well, their biggest bets are working out, why are the funds still underperforming? Part of it is fees because they’re active managers and you have to pay them to manage your money. But the other part was it pointed to a lack of winners throughout the rest of the portfolio. What I wanted to dig into was what does the hit rate, the win rate, look like in the rest of a portfolio and does that explain anything further about the performance of active funds and why they do or don’t outperform.

Fund Managers’ Hit Rates

Hampton: You looked at mutual fund managers’ hit rates. Explain what a hit rate is and what you were hoping to find out.

Shannon: A hit rate, I define it—it’s not a technical term, it’s a created term—but it’s the percentage of their stock picks that ended up outperforming the index over their holding period. So, you buy a stock today and then you hold it for two years, did that stock end up beating the market? There’s obviously trading going on in between those periods, and so you can quibble with whether that’s the right metric to use. But from that, you can get a percentage of their stock picks that were winners. The idea is everyone knows the story of active management and the aggregate underperforming of passive options. I was wondering, are they underperforming due to finding fewer winners? Are they just worse at finding winners than the market is overall? Or are they underperforming for a different reason, namely, position sizing? And so, this was an attempt at exploring if we could find an answer to that question.

Active Fund Managers’ vs. Passive Index Fund Managers’ Stock-Picking Performance

Hampton: How did active managers’ stock-picking records compare to passive index funds’ performance?

Shannon: They usually are pretty close. It answers the question of are active managers worse stock-pickers. Generally not. No. So, the passive hit rate is basically if you owned a passive fund, what percentage of the holdings in that passive option, i.e., the index, would outperform the index itself going forward? It depends on what universe you look at, but it’s usually 40% to 45%. So, a lot of people think that it’s sort of a coin flip that a stock is going to outperform. It’s actually worse than that. The odds are even tilted more against you into sort of randomly stumbling upon a winning stock. And why is that? Because markets are kind of concentrated. And so, the returns of an index over time are driven by relatively few holdings. And so, if you’re a manager, you need to find a way to beat that sort of concentrated return stream. And so, you see some active funds that do have high hit rates, higher than the index, and you might think to yourself, “Oh, that’d be a great fund to invest in.” But they still underperform the index because their winners were not weighted the same, were not their biggest holdings. They were maybe their smaller holdings. And so, even though you might have more winners than the index, you can still underperform because you just simply couldn’t weight the portfolio correctly.

How an Active Mutual Fund Can Underperform Despite Holding Winning Stocks

Hampton: And I think you just got into this, but I want to be sure that we hit home on it. Talk about how an active mutual fund could hold several winning stocks but still underperform the index.

Shannon: Yes, it’s all about the weighting. If you think about the Russell 1000 Growth, which is a highly concentrated index, almost 50% of the assets are in the top 10 positions. You can be a large-growth manager and you can have a 50%-plus hit rate, which for large growth would be very good because for large growth, the typical hit rate in the passive options is under 40%. So, a much more concentrated return stream there. But you can have a 50%-plus hit rate. You can pick more winners than losers. But if your opinion on those 10 huge stocks in the index is wrong, then it doesn’t really matter. You get washed out just because of the magnitude of those holdings. We saw that a lot with large growth specifically. If you graphed hit rate on the x-axis and performance on the y-axis, it was a purely almost random scatterplot. There was almost no relationship in that universe between hit rate success and actual fund success.

High Hit Rates and Topping the Index

Hampton: What was the recipe for racking up high hit rates and topping the index?

Shannon: You kind of had to be in the right universe. The sort of stock-picker’s market that a lot of you hear fund managers talk about kind of doesn’t exist in large-cap land. Again, it’s just too concentrated for that to really work. When you get down to the mid-cap space and the small-cap space, that’s where you do start to see a bit more tight relationship between hit rates and fund outperformance, and that’s simply because the indexes are more sort of dissolved and they’re less concentrated. And so, if you have a 100-stock portfolio where everything is 1% and you pick 50%-plus winners, chances are that’s actually going to do better than the index, which is going to have lower-percentage, lower-sized holdings, and, again, it’s going to be most likely under 50% hit rate for them. So, small- and mid-cap space, it’s more of a stock-picker’s land than the large-cap space where it’s really about having opinions on big stocks.

When Did Fund High Hit Rates Matter More or Less?

Hampton: When did hit rates matter more and when did they matter less?

Shannon: Again, it’s all about where you are in the style box. If you’re a small-cap manager – and also growth and value come into play, too, where growth indexes tend to be more concentrated than value indexes just because there’s no cap on how high a stock can go, but there is a cap on how low they can go. They can only go to zero. So, value indexes are naturally more diffuse than growth indexes. Across the different market-cap spectrums, you do see on the growth-value spectrum that growth is less associated with hit rate. Success in growth land is less associated with hit rates than in value land where it’s again a more diffuse index and sort of more of a pure stock-pickers market.

Can Investors Set It and Forget It?

Hampton: We’re going to do an example now. Let’s say an investor has found an active mutual fund with a winning stock-pick record that beat the index, Jack. Can they invest in it and sort of set it and forget it?

Shannon: Well, I love set it and forget it overall. I think it’s a great investment style. I think you’re better off setting and forgetting anything than you are trading and trying to go in and out of things. But to your specific question on a fund that has a high hit rate and has underperformed, I didn’t find a whole lot of persistence in performance, meaning, yesterday’s strong stock-pickers were not today’s strong stock-pickers. And so, I did find a pretty clear relationship between stock-picking success and the percentage of funds that underperform a benchmark. It does a great job backward sorting on that kind of metric, but then when you pull it forward and say, “Can I look at today’s hit rates and that will help me predict tomorrow’s performance,” that’s when it gets to become all noise. The only area that I think people could have a little bit of an informational edge is on the worst side. If there’s a fund that has a very bad track record and has not a good hit rate, there are signs that those bad stock-pickers do persist. So, good ones don’t persist, but bad stay bad is the takeaway. No one wants to buy a bad one anyway, but you might be holding one.

Hampton: So, good may stop being good, but bad continue being bad.

Shannon: Right. Yeah.

Do-It-Yourself Investors Looking for Funds With High Hit Rates

Hampton: All right. What would you tell a do-it-yourself investor, Jack, who is interested in pursuing a fund with a high hit rate?

Shannon: I think for do-it-yourself investors, I think this research is important because these are professional money managers who have literal floors of analysts, they have almost unlimited travel budgets, unlimited data budgets. They’re looking at a stock from every angle imaginable, and yet they’re still picking less than half their stocks correctly. So, if you’re a do-it-yourself investor and you’re thinking to yourself, “Well, you know, why am I paying a portfolio manager to manage my money? It doesn’t seem that hard. I can pick 50 stocks.” This says you better be careful because I assume most people don’t have the budgets that a lot of these groups—some people might but I don’t—have to do all this in-depth research. And so, if you’re not going to have an informational edge, it’s going to be very hard to find these winners. And if you can’t, then we’re going to be back at the same place we started, which is all about position sizing, and you’re just going to get lucky that your winners were the bigger-sized positions because that’s ultimately what’s going to determine outcomes is your portfolio construction piece of it, which is the trickier part to do.

Hampton: Well, everyone listening, check out the show notes for a link to the conversation Jack and I had about big bets back in January. Thanks, Jack, for coming back to the table—it’s always a pleasure—and sharing your research.

Shannon: Thank you. Happy to be here.

Hampton: That wraps up this week’s episode. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen and associate multimedia editor Jessica Bebel. And thank you for watching “Investing Insights. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.