Why do active managers find the S&P 500 so hard to beat?

In his book More Than You Know – Finding Financial Wisdom In Unconventional Places, Michael Mauboussin takes a different approach to the question.  He starts by assessing the competition - the index - and what its investment approach is.

In his scouting report, he points out that the S&P 500 selection committee “does no economic forecasting, invests long-term with low portfolio turnover, and is unconstrained by sector or industry limitations, position weightings, investment-style parameters, or performance pressures.” 

That’s what an actively-managed U.S. equity fund is up against - a disciplined competitor that keeps it simple and is not bound by false constraints or short-term pressures.  The S&P 500 is also not burdened with a high management fee (investors can buy an exchange-traded fund for a fraction of 1%). 

The S&P is a tough competitor, but in his book Mr. Mauboussin discusses four attributes of managers that have beaten it for the 10-year period ending December, 2004.  They are:

1. Low turnover – The firms that beat the market had portfolio turnover of 27% per year compared to the average for all equity funds of 112%.
2. Portfolio concentration – On average, the winning funds held fewer stocks.
3. Intrinsic-value investment approach – The winning fund managers focused on buying stocks that are trading below their true value.  They were not overly influenced by the makeup of the index they were trying to beat, namely the S&P 500.
4. Diverse geographic locations – Very few of the managers that beat the index were from New York and Boston.

By no means do these attributes guarantee success, but the odds go up.  And they go up even further if you have:

5. Smart people with a good disposition for investing – The portfolio manager has to be comfortable going against the grain, which means he/she is willing to be wrong...on their own...from time to time.
6. A supportive and stable environment – An independent-thinking manager has to be working at a firm that is comfortable being different and has chosen its clients accordingly.  
7. A beatable benchmark – Some indexes are easier to beat than others.  The S&P 500 is one of the tougher ones, while our index, the S&P/TSX, has historically been much easier.  Active managers should play in an arena where they have a good chance of winning.
8. Reasonable fees – It helps a lot.

To beat the index in the long term, you need to ignore it in the short term.  This is hard for portfolio managers to do, because they are constantly being assessed (daily) against a benchmark.  And it is why the S&P 500 is so hard to beat.