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Key Takeaways
- Active large-cap funds underperformed their benchmark index for the third consecutive month in July, even as improving market breadth increased managers’ odds of picking a winning stock.
- Large-cap funds lagged the Russell 1000 at the highest rate in more than a year last month.
- Small-cap funds also missed the rally, with just 14% of funds beating the Russell 2000’s 10.2% return.
Fund managers were more likely to pick a winning stock in July than at any other point in the last 20 years, and yet most didn’t, according to data from Bank of America Securities.
Just 31% of actively managed large-cup funds beat their Russell 1000 (RUI) benchmark last month, the lowest rate in more than a year. Fund performance lagged the market even as breadth improved, with 68% of stocks beating the S&P 500 (SPX) in July, the highest share since 2001.
The market was shaken last month by a soft inflation report that boosted Wall Street’s confidence the Federal Reserve would cut interest rates in September. That prompted a sell-off of the big tech stocks that have led the market for the last year and a half. At the same time, investors piled into the small-cap stocks that could benefit most from lower interest rates.
The rotation was abrupt and dramatic. In the week following July’s inflation report, the Russell 2000 outperformed the tech-heavy Nasdaq 100 (IXIC) by more than 13 percentage points, its largest stretch of outperformance since 2001 and the third-largest on record.
Why Fund Managers Fell Behind The Small Cap Rally
Fund managers were caught off guard. “Funds were heavily underweight Small Size and High Dividend Yield, two of the top performing factors last month, and overweight Momentum, one of the biggest laggards,” wrote BofA Securities analysts in a note Monday.
Even managers of small-cap funds, which benefited from the rotation, weren’t prepared to capitalize on the shift. Only 14% of small-cap funds beat the Russell 2000’s (RUT) 10.2% return last month, the lowest beat rate since December.
To be sure, active large-cap funds are still doing better this year than they normally do. Roughly half of such funds are running ahead of the Russell 1000 so far this year, compared with the 37% annual average since 2003.
However, much of that outperformance can be attributed to a strong start to the year. July was the third consecutive month in which active funds underperformed their benchmark. In those three months, just 26% of funds beat the Russell 1000.