January was great for stock pickers, but can they keep this up?

Over the past two decades, stock picks have had a dismal track record. Most have failed to beat the overall stock market.

But occasionally there are exceptions. In some periods, stock pickers rule, and the beginning of this year was one of those times.

In fact, it was the best January for actively managed stock funds since Bank of America started collecting data in 1991. It wasn't just that they delivered good returns for investors. The entire stock market did. The S&P 500 and other stock indexes set records this month.

Active stock funds did even better, albeit not by much, beating several market indexes by less than a percentage point on average. Still, for these funds – in which managers buy and sell individual stocks as they please – it was the best month since 2007. That happened to be the best calendar year for stock pickers in decades.

There is no way to know how long this streak of outperformance will last, or why it has existed in the first place. But it's entirely possible that this will continue for the rest of the year, and buying an average actively managed fund will seem like a brilliant move. Index funds that reflect the entire market could be falling behind.

That said, I think it's unlikely that active fund managers will gain the upper hand in the long term. The reason is that history shows that it is simply too difficult to beat the market.

A random walk

For a deeper perspective on market history, I called Burton Malkiel, the Princeton economist who wrote “A Random Walk Down Wall Street” in 1973. The 15th edition of the book was published last year, on the occasion of the 50th anniversary.

“I wrote in that book that a blindfolded chimpanzee could pick both stocks and experts,” he said, laughing. He explained that it was never his intention to denigrate stock pickers. He just wanted to make the point that while the stock market tends to rise in the long run, no one knows what it will do from day to day. So trying to outsmart the overall market is fruitless for most people.

“The historical record shows that the insight is correct in principle,” he said. That will likely be the case in the future, he added.

Professor Malkiel is now the Chief Investment Officer of Wealth front, an automated investment firm that uses index funds and avoids stock picking. However, when he wrote “A Random Walk Down Wall Street,” there were no commercially available index funds available; it would be three years before Vanguard's Jack Bogle started the first one. But Professor Malkiel, who later became director of Vanguard, wrote at the time that index funds would become the essential form of investing and that stock selection would not prevail in the long term.

The market is simply too 'efficient' for that, he told me. “That means information is quickly reflected” in prices, he said. “It does not mean that the prices are always 'good'. They are not. They are constantly changing. But no one knows for sure whether the prices are too high or too low, or where they are going. There's no way to know for sure. Too much is happening. And this is why most active managers can't do better than you in the long run by investing across the market with an index fund.”

We spoke on Tuesday, shortly after the monthly report on the consumer price index came out better than the market expected, and stock prices fell at the time. “These kinds of things happen all the time,” Professor Malkiel said. “Who knows where the stock market will go from here? I don't think you can know.”

People on Wall Street considered his perspective to be outright “heresy” when he began popularizing it, and it is still somewhat “controversial,” he said, because many managers continue to try to beat the market, and although it is difficult, some do that actually..

“It is certainly possible to beat the market,” said Professor Malkiel. And there are certainly periods, like January, when most active fund managers get it done.

But the basic truth is that over a decade or more, roughly 90 percent of active managers have failed to beat index funds, and those that have succeeded rarely repeat for long.

A Hot Streak in January

It's hard to overstate how good January was for active managers.

Whatever major benchmark Bank of America analysts used, active managers excelled.

Compared to the Russell 1000 index, which tracks publicly traded stocks with the highest market value, 73 percent of actively managed large-cap stock mutual funds had better returns. They exceeded the index by an average of 0.57 percentage points. Similarly, 61 percent of actively managed stock funds outperformed the S&P 500.

This pattern also applied to investments in smaller companies. Of actively managed funds benchmarked against the small-cap Russell 2000, 86 percent beat the index. Compared to the Russell Midcap Index, 64 percent of actively managed funds performed better.

How fund managers did this as a group is not clear, but there are some possible explanations.

For large-cap stocks, Bank of America found that active managers generally deviated from their benchmark indexes by focusing on high performers like Microsoft and Meta, fueling investor enthusiasm about the prospects for leveraging artificial intelligence applications. The bank didn't mention Nvidia, but the company, which makes chips that power AI, has outperformed the overall market, and increasing ownership of its shares would give a fund an edge over the indexes.

At the same time, some large-cap equity funds have reduced their holdings Tesla and Apple, which fell in January in response to sales increases.

But the relative performance of these and other companies will likely change, and when that happens, there is no guarantee that active managers will get their stock selection right.

A bit of history

Since 2001, most active managers have not made the right choices.

As I noted, a long-term and detailed study of fund performance by S&P Dow Jones Indices shows that active managers have not beaten the market. Midway through last year, active equity fund managers lagged the market:

• 93 percent of the time for 20 years.

• 90 percent of the time for 10 years.

• 73 percent of the time for five years.

• 72 percent of the time over a year.

Even when individual fund managers have beaten the indexes, they have rarely done so repeatedly and consistently. For example, as of June 2022, no fund finished in the top quarter among actively managed funds every year for five consecutive years.

One reason for this continued failure is that actively managed funds generally have higher expenses than passive index funds, and this hurts their performance.

Nevertheless, actively managed funds have occasionally shown outperformance. Since 2001, active managers have outperformed the S&P 500 in 2005, 2007 and 2009. In 2007, the best year for active managers, 45 percent beat the index.

“It definitely happens from time to time,” he says Anu R. Ganti, senior director of index investing strategy at S&P Dow Jones Indices. “It's too early to say, but this could be one of those years. It's just that, based on the probabilities, the outperformance of active managers probably won't last long.”

I'll be keeping a close eye on the horse race between active managers and the indexes, and I personally expect to settle for whatever the market averages bring. If you can do it, it's exciting to beat the market. Falling behind is a lot less fun, and unfortunately that's what usually happens to those who have tried to outsmart the market.