Since a handful of stocks account for most of the market's gains, having a diversified portfolio may actually lower returns.

This time was supposed to be different. It would be a stock picker's market where smart active investors would stop lagging the index and show what they are capable of. Yet active management continues to underperform.

Efficient market proponents say most managers can’t outperform the market. But there’s another underappreciated structural problem that dooms active managers today: We’re in a period of “narrow markets,” where a handful of stocks — the “Big Seven” — including Apple (AAPL.O), Microsoft (MSFT.O), Alphabet (GOOGL.O), Amazon (AMZN.O), Nvidia (NVDA.O), Meta Platforms (META.O) and Tesla (TSLA.O) — account for the vast majority of market returns. As a result, any manager who builds a well-diversified portfolio will inevitably underperform because holdings outside the “Big Seven” drag down performance.

According to Morningstar, just 18.2% of actively managed mutual funds and exchange-traded funds benchmarked to the market-cap-weighted S&P 500 outperformed the index in the first half of 2024. That’s down from 19.8% in 2023. Over the past decade, an average of only 27.1% of actively managed funds benchmarked to the S&P 500 have outperformed the index each year.

The outlook for active managers has been particularly limited in the first half of this year, as the “Big Seven” have accounted for almost 60% of the S&P 500’s total return. These seven stocks also account for more than half of the S&P 500’s performance in 2023. Their outperformance means they have captured about 30% of the total market value of the S&P 500. The American biweekly magazine New York called this “the greatest concentration of capital among a small number of companies in the history of the U.S. stock market.”

If you run a concentrated portfolio and own all seven stocks, you will be very successful. But most managers have a diversified portfolio, in which any single stock usually accounts for no more than 5%. This means that if you get all the "big seven" quotas through wisdom or luck, it will only account for 35% of your portfolio (seven stocks times 5%). The other 65% must be made up of underperforming stocks, many of which will drag down overall performance.

But these were all in the first half of 2024, you might say; the “Big Seven” has cooled slightly since then, and in normal markets, managers have a better chance of getting it right. But it turns out that normal markets tend to be narrow markets. Before the “Big Seven,” remember there were the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google). In 2017, the average return of these five stocks was nearly 50%, while the S&P 500 returned 21.8%. FAANG stocks accounted for more than 10% of the S&P 500’s market value and contributed 4.3 percentage points to the overall market’s 21.8% return in 2017. By 2020, the market value of FAANG stocks soared to 20% of the total index value, the highest concentration in S&P 500 history.

Before the Big Seven and the FAANGs, there was the narrow market of the late 1990s: The Four Horsemen -- Microsoft, Cisco (CSCO.O), Oracle (ORCL.N) and Intel (INTC.O) -- led the market higher in the 1990s tech boom. In 1999, those four plus Dell (DELL.N) accounted for about 42% of the total market value gain of all 500 companies. Looking back half a century, the "Nifty Fifty" (companies like Sears, Eastman Kodak and Polaroid) have generated disproportionate returns in a handful of stocks, despite the thousands of publicly traded stocks.

The prevalence of narrow markets suggests that constructing a typical institutional portfolio of 80 to 100 stocks may inevitably reduce rather than improve returns. But most managers know that they need to offer a broadly diversified portfolio with dozens of names because a "concentrated portfolio" is viewed by most investors as a specialty product that is too risky.

Some active managers are notorious for "stealth indexing" -- constructing portfolios that are nearly identical to the S&P 500, thereby guaranteeing that the results won't deviate too much from the benchmark. But how do you construct a stealth narrow-market portfolio? You could offer a concentrated portfolio of 25 stocks, and if you get most of the "Big Seven" stocks, or the "elephant" group of stocks at that moment in time, you'll do well. But that's a huge market risk -- and a huge marketing risk.

In short, as long as the market is narrow, stock pickers face a difficult task.

The article is forwarded from: Jinshi Data