Returns Are Dominated by Very Few Stocks and Very Few Months
Most investors know that small-cap stocks and value stocks have provided higher returns than large-cap and growth stocks. What most investors may not know is that those excess returns come from a very small number of stocks.
For example, the 1997 study "On the Robustness of Size and Book-to-Market in Cross-Sectional Regressions," found that the negative relationship between size and returns is driven by a very few extreme positive returns in each month -- when only 1 percent of each month's observations are trimmed, there's a significant positive relationship between firm size and returns (large-caps now outperform small-caps). They called this the "turtle eggs" effect: "Investors who own small-cap stocks anticipate a few major successes and many minor disappointments. That is, they lay many "turtle eggs," hoping a few will hatch and make it to the ocean."
Here's another example of how the performance of a small number of stocks explain much of the returns of an asset class. From 1926 through 2009, equities (as measured by the CRSP total market index) returned 9.6 percent per year. If you exclude the top 10 percent of performers, the return falls by more than one-third to 6.2 percent. If you exclude the top 25 percent, the return becomes slightly negative, -0.6 percent. Thus, the top 25 percent of performers accounted for more than 100 percent of the returns.
Of course, if one could eliminate the bottom 10 or 25 percent of the performers, returns would increase just as dramatically. Unfortunately, the evidence demonstrates that after accounting for expenses, active managers have been persistently unable to generate alpha by identifying the star performers and avoiding the losers.
This finding provides a valuable insight for investors in terms of choosing between active and passive management as the winning investment strategy. There are thousands of small-cap firms. No researcher or active manager can possibly follow all of them. Investors must ask themselves: If the excess returns from small-cap stocks come from just 1 percent of the companies, is it likely that an active manager will be able to identify the few "turtle eggs" that will make it to the sea?
Here are two more examples of how much of the excess returns are driven by very few stocks. First, of the 500 firms selected for the original S&P 500 Index in 1957, only 74 remained on the list in 1998, and only 12 outperformed the index over the entire period. Second, my colleague, Vladimir Masek, found that of the 500 companies in the S&P 500 as of October 1, 1990, only 302 (60.4 percent) were even still in existence 10 years later. Of the 302 (which certainly includes survivorship bias; many companies that didn't survive in all likelihood produced poor returns), only 79 (26.2 percent) beat the Vanguard 500 Index Fund (VFINX). Perhaps even more surprising is that 74 stocks (24.8 percent) returned less than riskless one-year Treasury bills. Forty-five stocks (14.9 percent) returned less than inflation. And, perhaps most important from a risk management perspective, 32 stocks (10.6 percent) had negative returns.
Peter Knez and Mark Ready, authors of the aforementioned 1997 study, provided another valuable insight for investors in developing the winning investment strategy. They found that the negative relationship between firm size and returns could be entirely explained by the 16 months (out of over 30 years of data) with the most extreme returns. This finding has powerful implications for investors -- the most likely way to earn the small cap premium is to be there all the time.
Here's another example demonstrating the difficulty of timing the market -- because so much of the market's returns occur over such short, and totally unpredictable, periods. There are 1,020 months in the 85-year period 1926-2010. The best 85 months, an average of just one month a year or just 8.3 percent of the months, provided an average return of 10.7 percent. The remaining 935 months (91.7 percent of the months) produced virtually no return (just 0.05 percent).
The above examples demonstrate how difficult it is to find the proverbial needles in the haystack. The winning strategy is simply to own the haystack, and own it all the time.
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