The Challenge of Outperforming Indices Amid Dominance of Megacap Stocks

Key Takeaway

• Fund managers face increased pressure to outperform indices, shifting focus from capital preservation to relative performance.
• Dominance of megacap stocks like Nvidia Corp. is central, with a 35% rise in the Dow Jones Global Titans index versus a 21% increase in the MSCI World Index.
• Outperformance now hinges on heavy investment in megacaps; only 2.5% of UK actively managed funds beat the Titans last year, emphasizing US, growth, and tech stocks.

The Challenge of Outperforming Indices

In the evolving landscape of asset management, the pressure on fund managers to outperform market indices has intensified, marking a significant shift from the early days of collective investment vehicles. Historically, fund managers focused on beating inflation, cash, or government bonds without the need to consider the performance of others. However, modern fund managers are now benchmarked against various indices, with a performance evaluation period that does not exceed five years. This shift towards relative performance evaluation has introduced a new set of challenges, as it diverges from the primary concern of investors, which is capital preservation rather than outperforming a spreadsheet. The emphasis on not underperforming an index may lead to portfolio strategies that closely replicate the index, making it difficult to achieve superior returns.

Dominance of Megacap Stocks

The current market environment is characterized by the extraordinary dominance of megacap stocks, particularly in the United States. Over the past 12 months, the Dow Jones Global Titans index, which represents the 50 largest companies worldwide, has seen an approximate 35% increase. This contrasts with a 21% rise in the MSCI World Index and a 14% increase in its equal-weighted counterpart. This disparity highlights the significant outperformance of the largest companies, making them the benchmark for success. According to GMO, a fund management firm, 90% of large-cap blend managers have underperformed the S&P 500 Index over the last decade. In the UK, research from Downing shows that only 2.5% of actively managed funds have outperformed the Titans in the last year, with successful funds typically having a bias towards US, growth, and technology stocks.

The Path to Outperformance

Achieving outperformance in this market has predominantly required a substantial investment in megacap stocks, such as Nvidia Corp., which has a 3.4% weighting in the MSCI World Index. Downing's research indicates that the average outperforming fund holds a 5.33% stake in Nvidia. This strategy of betting on megacap exceptionalism and maintaining higher weightings in these stocks than their already significant presence in indices is fraught with challenges. It requires a high degree of courage to assume such stock-specific risk, especially given the current high valuations. Additionally, compliance departments often restrict such concentrated positions due to risk management considerations. The current market conditions suggest that this narrow path to outperformance may be the only reliable strategy, raising concerns about the future of active management if megacap growth continues unabated.

Street Views

• Nigel Morecraft (Neutral on the asset management industry):

  "In those happier times, the first big collective vehicles aimed at retail investors in the UK bought portfolios of 25 or so stocks, mostly with an income bias... typical managers did nothing but maintain the portfolio in 'an administrative capacity.'"

• Alex Paget, Downing (Bearish on active fund performance relative to Titans):

  "2.5% of them have outperformed the Titans in the last 12 months."