How 1 Fund Beats Its Benchmark, Year After Year After ...

For active managers, the math is stark. Out of thousands of mutual funds, literally only one beat the Nasdaq 100 over the last five, 10 and 15 years. It did so by boiling down stock picks to about two dozen companies and riding almost all of them to gains.

Ron Baron, the 80-year-old Wall Street veteran who still oversees the fund, says his secret is combining an unwavering faith in entrepreneurs like Elon Musk with just enough paranoia to call firms in his portfolio almost every day to make sure nothing is amiss.

But Baron’s success belies the fact that for most stock pickers, beating market indexes by betting big on a few names is a strategy with exceedingly dismal odds. That’s especially true in this tech-powered era of the Magnificent Seven.

The vast majority of such efforts will probably crash and burn, according to a new paper by former New York University professor and quant manager Antti Petajisto. Why? Because the market coughs up too few winning stocks for the tactic to succeed except in rare cases.

The futility of playing against benchmarks like the Nasdaq 100 was underlined in a report last month by Bloomberg Intelligence, then got a widespread public airing by investor Chamath Palihapitiya, who said indexes provided superior gains “without you having to do any work or diligence.”

Turns out intellect and hard work are pretty useless, too, thanks to dynamics that have increasingly come to dominate the active-management debate.

“Concentrated stock positions are significantly more likely to underperform than to outperform the stock market as a whole over the long term,” wrote Petajisto, currently head of equities at Brooklyn Investment Group. “Trying to gamble on identifying those few stocks with outsized returns would be a bad idea.”

Even in a U.S. market that has risen sixfold since the global financial crisis, the number of stocks that has matched that benchmark return can be pitifully few. In fact, over the past century, the median 10-year return among the 3,000 largest U.S. stocks has lagged the broader market by 7.9 percentage points, according to the paper.

The trend might even be intensifying in the winner-takes-all modern economy. While the Russell 3000 is up 15% in 2023, the median return is about a 0.7% drop. A little more than half of the constituents are down.

In another sign of mega-cap strength, an equal-weighted version of the S&P 500 has trailed the regular value-weighted one by 12 percentage points this year, on track for the worst underperformance since 1998.

That puts active managers in a bind. Hug the index and you can’t justify your higher fees. Deviate from it and you risk missing out on the big gains of, say, Nvidia Corp. or Tesla Inc.

Predictably, a larger portion of managers that held all Magnificent Seven stocks beat their benchmarks on a one-year basis, writes David Cohne, a Bloomberg Intelligence analyst. But this wasn’t all too common: Just 18% of 971 mutual funds owned all seven names while 21% held none of them.

“Beating benchmarks, underpinned by those same seven stocks, required managers to make other fortuitous picks,” he says in a note.