Will 2022 be a better year for stockpickers?

UK fund managers seem to have lost their mojo. This year, less than half of the funds in Trustnet’s database of all companies’ unit trusts have out-performed L&G’s index fund, whereas in 2019 and 2020 around two-thirds did so.

In fact, though, there has been no loss of ability. What’s changed is that 2021 has been less of a stock pickers’ market than 2019 or 2020 were, so stock pickers have been fishing in less well-stocked waters.

To see how, remember that the All-Share index is weighted by market capitalisation which means that Diageo (DGE), with a market cap of £92bn, is 70 times as important for the index as the typical FTSE 250 stock with a market cap of £1.3bn, such as Plus 500 (PLUS) or Jupiter Fund Management (JUP). And the four biggest stocks in the All-Share (Unilever (ULVR), Royal Dutch Shell (RDSA), AstraZeneca (AZN) and Diageo) are worth more than the entire FTSE 250. This means that if Diageo or another mega-cap stock does badly it will drag down the index causing most shares to outperform it. If this happens then somebody who picks stocks at random with average luck will beat the market. Conversely, if the mega-caps do well they will drag up the index and most stocks will underperform it, causing the average stock picker to underperform.

And this is the story of active fund management in recent years.

2020 was an abominable year for mega caps, with HSBC (HSBA), Royal Dutch Shell and BP (BP.) all falling heavily as they cut their dividends. This dragged down the index, causing most shares to outperform it. And so most funds beat the market.

This year, however, the opposite has happened. Mega caps have had a great year, with BP, Royal Dutch Shell and Diageo all doing especially well. The index has thus been dragged up in part by just a few stocks, which means that very many have underperformed it. And so stock pickers have had a harder time.

This is a normal pattern. My table shows the (unweighted) average price change of the seven biggest stocks in the index. This shows that in years when these seven beat the market, active funds do badly: this was the story of 2021, 2018 and 2016. Conversely, in years when the big seven underperform, most funds do well; this happened in 2019 and 2020. And when the big seven do about as well as the index, so too do funds: this was the case in 2017.

This isn’t to say that 2021 has been terrible for stock pickers. The performance of the big seven is only one measure of the extent to which it is a stock pickers’ market or not. There’s another measure, which has helped stock pickers this year. This is the performance of small caps relative to the FTSE 100. When small caps outperform the FTSE 100, most shares beat the market which helps stock pickers. And this was the case this year – which is why as many as two-fifths of funds beat L&G’s index tracker despite the big seven doing well.

Again, there’s a pattern here. Years in which small caps beat the FTSE 100 are years when most funds beat the index – such as 2019 and 2020. But when the FTSE 100 beats small caps, most funds underperform the index, such as in 2016 and 2018.

Fund managers did not suffer a collective bang on the head at the start of this year which caused them to lose the ability they had in 2019 and 2020, any more than they had an injection of superpowers at the end of 2018 to end their underperformance. It’s just that sometimes the environment favours active funds, and sometimes not.

There’s a reason why we underappreciate this. Psychologists call it the fundamental attribution error; we attribute outcomes too much to individual character and too little to environmental forces.

“It’s a stock pickers’ market” is a cliché. But it is sometimes – and only sometimes – true. What matters here is not the market direction. In falling markets, active managers can sometimes outperform (as in 2020) and sometimes underperform (as in 2018). Equally, they can sometimes beat rising markets (as in 2019) and sometimes under perform them (as in 2016). Instead, what matters is the distribution of returns: if most stocks beat the index most funds will, and if most stocks underperform, so will most funds.

Which poses the question: will 2022 be a stock pickers’ market? We must be modest here. Mega cap stocks are well researched and so we cannot say with confidence whether they are mispriced. What we can say is that the FTSE small cap index is near a 30-year high relative to the FTSE 100, suggesting they are expensive. If they underperform – which would be more likely if the domestic economy falls short of expectations – fund managers will have a tough time.

Here, though, I declare an interest. My equity investments are all in tracker funds, one of which is L&G’s index fund. Those people who believe that next year will be a stock pickers’ market are testing a reasonable hypothesis – but they’ll not be doing so with my money.