Narrow Stock Market Returns Spell Danger for Investors

Just a few large companies have provided outsized returns this year.

ByABC News
December 7, 2015, 9:58 AM
A general view of the charging bull statue also known as the Wall Street Bull is seen, March 5, 2012, in New York.
A general view of the charging bull statue also known as the Wall Street Bull is seen, March 5, 2012, in New York.
Ben Hider/Getty Images

— -- This year, the stock market has had a bad case of the narrows — the narrowing of great returns to just a few stocks. This has been one of the rare years when nearly all the returns in the market can be traced to just a handful of companies.

While investors have enjoyed outsized returns from these high-fliers, their stellar performance is all that’s propping up many mutual funds. Many investors, especially those who own large-company index funds, may not be aware of the risk this creates.

Among the stars driving the market this year are Amazon, General Electric, Alphabet (aka Google), Microsoft and Facebook, which have accounted for nearly all of the gains in the S&P 500 index. As investors pour more and more money into securities tied to indexes like the S&P, their returns on this investment have come from a smaller and smaller subset of stocks. By comparison, 2013 and 2014 saw the 10 largest stocks account for less than 20 percent of the year’s S&P 500 growth.

What does this year’s narrowing mean for investors? In the dozen or so times that narrowing has occurred in the last 30 years, it has often preceded a downtrend in the stock market. This time around, some Wall Street pundits see this narrowing as a sign that the bull market may be about to end.

These pundits may be right, but I have another view. The market bull may not be finished running, but regardless of whether this happens in the coming months, we may be entering a period when active mutual fund managers -- who choose stocks for their funds rather than trying to match the returns of an index -- are poised to beat index funds, which are passive investments whose holdings reflect a given index and thus require no real management. This would be a reversal of a long-running active-versus-passive scenario over the past 15 years, where investors have flocked to index funds and four out of five active managers have failed to beat their benchmarks.

One reason for the superior overall performance of index funds is lower costs. It’s much cheaper to maintain an index fund than to research and choose individual stocks. But those who joined the stampede to index funds may be surprised to learn that active managers actually play an important role, especially in times of market turbulence. During the 2008-2009 market meltdown, active funds outperformed indexes. That’s because active managers can react quickly when markets swoon, providing at least some downside protection, while passive investors are fully exposed. Active funds can move into defensive positions while index fund investors must grin and bear it, staying the course and chanting the industry mantra about how passive investing delivers better long-term average returns. Of course, the question for many investors is: Does the timing of your retirement coincide with these long-term averages, or will a solid hit to your portfolio inconveniently come just before you retire?

As stocks like Amazon and Facebook surge to high valuations, active managers can take profits and pass them on to mutual fund shareholders, ensuring that these star stocks don’t become too big a factor in their funds. Yet with index funds, such stocks can become too big a factor, pumping up returns while creating vulnerability because of an over-reliance on these stars to produce returns. When these stars dim, the entire index fund may falter.