Most large-cap stockpickers faced difficulties in outperforming their benchmarks in 2023, primarily due to poor breadth. Despite the challenges, beating the stock market consistently has always been a tough task.
According to Bank of America, only 38% of large-cap active mutual funds managed to outperform their Russell benchmark in 2023. On average, these funds underperformed by 1.6 percentage points.
While there was a slight improvement in 2022, with 47% of funds beating their benchmark, the 38% hit rate in 2023 is still close to the historical average. As highlighted by BofA in a research note, the only time in the past two decades when the majority of active large-cap funds outperformed was in 2007, with a rate of 61%.
The primary reason behind the underperformance of most funds in 2023 can be attributed to the market rally driven by a small number of stocks. Last year witnessed the narrowest breadth year in history, dating back to 1987. Ohsung Kwon, equity and quant strategist at BofA Securities, explained that only 27% of stocks in the S&P 500 managed to outperform the index itself.
The low breadth made it extremely challenging for active funds to outperform the index, as there was a higher chance of not having stocks that were outperforming. Kwon further emphasized, "Unless you had the Magnificent Seven, it was a tough year for active funds to outperform."
The S&P 500 experienced a growth of over 26%, including dividends, in 2023. However, it was primarily driven by the performance of seven prominent tech stocks known as the Magnificent Seven: Apple, Amazon.com, Alphabet, Meta Platforms, Microsoft, Nvidia, and Tesla. These stocks accounted for 62% of the S&P 500's total return. Excluding this group, the index's return was 9.94% for the year 2023.
A Look Back at 2023: The Rise of the Magnificent Seven Stocks
The stock market in 2023 witnessed a remarkable performance by a select group of stocks, referred to as the "Magnificent Seven." These seven stocks, which make up more than a quarter of the S&P 500, propelled the entire index to new heights. Nvidia and Meta stood out as the top two performers, while Tesla secured a place in the top 10. Even Apple, considered the laggard among the group, experienced an impressive surge of over 48% for the year.
While the majority of stocks remained relatively dormant until November, when a significant rally took place, it was a banner year for value-focused stockpickers. Core and growth funds had a subdued year in terms of outperformance, with only one in three funds surpassing expectations. However, value funds shone brightly, with an impressive 57% beating the benchmark. This marked the fourth consecutive year of value funds outperforming expectations.
Kwon, an expert in the field, explains that the Russell 1000 Value Index had even greater breadth, as it did not include the Magnificent Seven. This provides further evidence of the wider impact of value-based investing throughout 2023.
Small-cap active funds faced difficulties in 2023, with only 36% managing to outperform the benchmark. This figure plummeted compared to previous years, such as 2022 when 72% outperformed, and 2021 when a staggering 85% achieved outperformance. Despite this challenging landscape, there is some good news for active stockpickers. BofA reports that breadth has begun to improve, with 60% of stocks outperforming the S&P 500 since November. This suggests that active funds may have an increased chance of selecting winning stocks in 2024.
For the rally to truly broaden its reach, however, cyclicals must join in. These stocks were slow to participate in the rally, only showing signs of momentum in November. With concerns about the economy and a potential recession easing and expectations of interest-rate cuts, cyclicals hold the potential to outperform. If this scenario unfolds, a broader participation in the rally is likely.
While many active managers struggled to keep up with the Magnificent Seven in 2023, the tide may turn in 2024. If the tech giants lose momentum and other stocks and sectors gain traction, diversified funds stand a better chance of outperforming.
