High beta differentiates stock pickers from index funds

Stock pickers had a rough year in 2011. For example the Fidelity Magellan Fund underperformed the S&P500 by close to 14%. And Fidelity is not alone.

Investor's Business Daily: Most mutual fund managers underperformed the market [in 2011], and many very badly. Morningstar data show less than a third (29%) of the 21,000 mutual funds it tracks beat their benchmarks. By contrast in 2009, when the bull market started, more than half (52%) of all funds did so.

What could be the reason for this trend? The answer is not straight forward. Some suggest that mutual fund fees cause the underperfomance and are the only thing standing between stock pickers and index funds. But if that is the explanation, why would a fund like Magellan underperform by so much - it couldn't just be their fees. The answer comes down to beta of the stocks they pick. Mutual funds know that in order to overcome their high fee hurdle, they need high beta equities that will beat the index in a rally in spite of the high fees. 2011 was a year of extreme uncertainty and investors dumped high beta stocks causing many to underperform.

But what happened to achieving superior performance with stock selection? That has been quite difficult to accomplish these days because of high correlations among stocks. In fact correlations have been close their 30-year maximum of 1986.

S&P100 Correlation (Source: Citigroup)

With correlations this high, the key differentiator among individual stocks is beta. Pick a low beta stock and risk underperforming the index in a rally. With high fees on top of that underperformance any manager will get investors' attention pretty quickly - negative attention that is.  Pick high beta stocks and risk underperforming in a market like we had in 2011. Pick a portfolio of stocks with an average beta of one and get an index-like return because of the high correlation we've had. But with  index-like returns how do you justify the fees? Stock pickers are in a no-win situation. And that is one of the reasons the mutual fund industry has been under considerable pressure these days.

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