The US stock market has reached new peaks in the first quarter of the year. Market optimism has been driven by President Donald Trump’s business-friendly policy proposals – the so-called Trumpflation trade. The NASDAQ tech index breached 6,000 for the first time in April, while the Dow Jones retook the 21,000 level it originally claimed in March.
Investors in passive funds have benefited directly from the rally. Both index-trackers and exchange-traded funds typically aim to replicate the performance of a given benchmark.
“The first S&P 500 fund, Vanguard 500 Index, was launched 40 years ago. Few actively managed US large-cap stock funds that were around in 1976 are still in existence today. Fewer still managed to produce better returns than Vanguard 500 Index over the past four decades,” said Ben Johnson, director of passive strategies global manager research with Morningstar.
Many people attribute active managers' collective struggles to beat index funds to the overall level of efficiency of the market for US large-cap stocks, said Johnson.
“Furthermore, given advances in information technology and the growth in the portion of investable assets that is managed by an increasingly skilled set of professional investment managers, it can be argued that the market has become ever-more efficient over time,” he said.
Higher correlations between stocks also make it harder for active fund managers to generate returns by picking the winners.
“When everything moves together when markets are risk-on or risk-off – as we have seen over the last few years – it is very hard for stock pickers,” said Peter Sleep, senior investment manager at Seven Investment Management.
Active Managers that Beat the Market
However, data from Morningstar Direct reveals one actively managed US equity fund’s performance beats both a similar tracker fund and a similar ETF over the long term.
The Gold Rated Dodge & Cox Worldwide US Stock fund uses the Russell 100 value index as a benchmark. We compared this actively managed Dodge & Cox fund with the Gold Rated Vanguard US Equity Index fund and the Silver Rated iShares Russell 1000 ETF (IWB), which both track the Russell 1000.
Russell 1000 is an index which gives investors exposure to the 1,000 largest US exchange-listed stocks after minimal screening for factors such as liquidity and public float. The Russell 1000 includes far more mid-cap stocks compared with the more well-known S&P 500.
Short-term, the figures don’t look good. Looking at this year’s performance, the actively managed fund Dodge & Cox Worldwide US Stock has gained 1.3%, however the benchmark is up 7.3% this year. The iShares Russell 1000 ETF is up 7.2% year to date while Vanguard US Equity Index is up 2% year to date.
Passive Funds Fail in 2012 and 2013
However, looking at each year’s performance over the past 10 years, the actively managed fund Dodge & Cox Worldwide US Stock outperformed iShares Russell 1000 ETF six out of 10 calender years.
Vanguard US Equity Index launched in 2009 so it only has a seven year track record to compare with the active fund. For the three years from 2012 to 2014, Dodge & Cox Worldwide US Stock gained 17.4%, 34.1% and 26.3%, ahead of Vanguard US Equity Index’s 10.7%, 30.3% and 19%.
Over five years on average, the Dodge & Cox Worldwide US Stock on has returned 20.7% a year, slightly ahead of Vanguard US Equity Index and iShares Russell 1000, on 18.4% and 18.8% respectively.
The Dodge & Cox Worldwide US Stock fund’s “impressive returns” in 2012 and 2013, placed it among the best in the US large-blend equity category, as its financials and technology stock picks paid off, said Fatima Khizou, Morningstar fund analyst.
“The fund had an average 2014; while its technology and financials holdings were strong, energy was a big detractor, and its healthcare picks were a mixed bag.” Khizou added.
Although there has been a sustained period of success in recent years, investors should also be aware of the relative and absolute weakness seen in the past, Khizou warned.
“The fund was negatively affected by the financial crisis in 2008, when large losses resulted from positions in a number of banking stocks, and similar weakness was seen in 2011. That said, the strategy has a strong long-term track record, and we believe investors who stay the course will continue to be rewarded,” said Khizou.
Heavy Bias on Financial and Tech Stocks
The Dodge & Cox Worldwide US Stock fund has 61 stock holdings in its portfolio at the moment. The fund is heavily weighted towards financial services stocks, making uph 29% of the portfolio. Technology is the second largest sector in the portfolio at 21%.
The Vanguard US Equity Index fund has 3,434 stock holdings, technology stocks consist of the largest part of the fund with 19%, following by financial services with 16%.
“This index-tracker provides a very low-cost, one-stop solution to gain access to US equities. At 0.10%, the fund’s ongoing charge is highly competitive. The index captures about 99% of the US equity market and as such includes mid-, small-, and micro-cap stocks, making this fund more susceptible to the effects of local economic changes,” said Monika Dutt, Morningstar passive analyst.
The iShares Russell 1000 ETF follows a full replication strategy, essentially holding all of the 1,030 or so stocks in the index, said Johnson.
“Because of buffers that reduce unnecessary turnover, the actual number of stocks in the index can vary. The fund has historically used securities lending to generate additional income in an effort to improve tracking performance,” said Johnson.
