How to Measure Good, Bad Stock Pickers

ETFs that track industry sectors can be an investor's best friend

Some ETFs track market sectors and outperform some components, too. Some ETFs track market sectors and outperform some components, too.

In the middle of today's bull market, you might expect a good performance from stock-picking fund managers.

If they can’t outperform major stock-market yardsticks like the S&P 500 when it’s breaking record highs (this time above 2,000), then at the very least they should be able to perform on par.

But have they? Typically, two-thirds of active fund managers lag the performance returns of low-cost broadly diversified index funds and ETFs.

During the first half of 2014, though, about three-quarters of active managers underperformed, according to a recent Vanguard study.

Indexes that track the performance of hedge fund managers show a similar pattern of widespread market underperformance.

Plus, since the recovery from the financial crisis of 2008, hedge funds as a group have lagged in almost every asset/strategy category.

Compared to mutual funds, hedge fund managers charge a premium for their stock-picking services. As most investors realize far too late, the premium paid is an awfully high hurdle to obtaining market-beating results.

The hedge fund industry, generally speaking, has turned into a playground of upper-class stock picking with low-class results. (Where are the customers’ yachts?) 

We know the track record of professional stock pickers is poor, because that’s what the numbers say.

We also know the track record of amateur stock pickers is even worse, but sometimes it’s more difficult to quantify with raw numbers.

Unlike professional money managers, we can’t group, categorize and neatly track the stock-picking performance of Uncle Jimmy and Aunt Ethel or the 50 million other gunslingers like them.    

Besides comparing investment returns to the broad indexes, investor can measure the lack of prowess of some stock pickers by comparing their selections to a peer ETF that matches the same industry sector as the stock.

Let’s look at three quick examples of how this is done.

Technology Sector SPDR ETF (XLK)

XLK tracks the 71 large-cap technology stocks within the S&P 500 and has gained 99% over the past five-years.

Yet, many technology stock pickers have been nuked by XLK’s five-year performance. Widely held stocks like Cisco, Microsoft, and Intel have all underperformed XLK. The worst offender is Cisco, which has lagged XLK by a whopping 86% since mid-2009!

Financial Sector SPDR ETF (XLF)

XLF follows the 84 large-cap banking and financial stocks with the S&P 500 and has increased 63% over the past five years. Even so, many individual stocks in banking and finance continue to underperform their peer sector ETF.

Widely held stocks like Bank of America (BAC), Citigroup (C), and Goldman Sachs (GS) have all underperformed XLF. Among this group, Bank of America was the worst performer, falling 5.2% in value.

Healthcare Sector SPDR ETF (XLV)

XLV contains 54 large-cap health and pharmaceutical stocks within the S&P 500 and has been a top performing sector, gaining 123% since mid-2009.

Meanwhile, popular healthcare stocks like Johnson & Johnson, Pfizer and Merck have lagged XLV’s five-year returns. Time for another aspirin!

Conclusion

The numbers don’t lie; stock picking is a loser’s game regardless of whether it’s being played by professionals or amateurs.

In the end, advisors can help the investing public understand that indexing a portfolio puts the odds of investment success in the client’s favor.

 

 

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