Safety in Numbers

by Craig L. Israelsen
University of Missouri-Columbia

From Financial Planning Magazine, July 2001. Reprinted with permission.

ne of the interesting statistics reported by Morningstar is the percentage of a companies stock which is owned by mutual funds. For example, as of 3/31/01, 17% of the stock issued by 3Com was owned by mutual funds, 20% of Southwest Airlines' stock was owned by funds, and so on. Of the 6,055 U.S. companies in the Morningstar Principia Pro database as of 3/31/01, 5,490 had valid data regarding the percentage of their stock which was held by mutual funds. Among that group, the average fund ownership was 10.6%. The stock of 580 companies was held by no mutual funds and 62 companies had 40% or more of their stock owned by funds.

Why is this figure of interest? As stated by Morningstar, "a high % fund ownership figure can be an indication of the market's overall belief in the value of a stock. Conversely, a low % fund ownership figure can indicate that the stock has not proven to be worthy of its valuation." So, a question naturally arises, "how good a gauge is % Fund Ownership in the performance of stock?" Or, said differently, "do companies whose stock is widely held by mutual funds tend to outperform or underperform the stock of companies that are less popular among equity funds?"

In attempting to answer this question let's first look at the results of the analysis of large cap U.S. stocks (Figure 1). From this point on I will refer to the % Fund Ownership figure simply as FO. The data in Figure 1 are divided into two one-year time periods, a bear market and a bull market. The bear market period, as measured by the performance of the Vanguard 500 Index fund, was from April 1, 2000 to March 31, 2001. The bull market year was from April 1, 1999 to March 31, 2000.

As shown in Figure 1, 26 companies had a FO ranging from 0 to 10% during the bear market period. The average return of those 26 stocks was 4.4%. These 26 companies, based upon low FO, were obviously not popular among mutual fund managers. The average return of companies with progressively higher FO during the bear market declined until the FO was in the range of 21 to 25% and above, at which point the average return improved markedly. For the 36 stocks with FO exceeding 30% the average return was 24.2%. This is quite impressive inasmuch as the Vanguard 500 Index fund had a return of -22% during this same time period.

Interestingly, the group of large cap stocks with the lowest return during the bear market period (FO of 11-15%) had the largest average market capitalization ($64.5 billion) while stocks with the highest average return during the bear market had the lowest average market cap ($18.2 billion).

Also shown in Figure 1 is the performance of U.S. large cap stocks during a bull market period. In general it appears that less popular stocks (those with lower FO) tended to have higher average returns. The stocks in the four smallest FO categories had sizeably higher average returns compared to the FO categories of 26-30% and 31% & above.

The relationship between average return and FO (shown graphically in Figure 2) provides some evidence that highly popular large cap stocks, at least those with high FO, tend to outperform low FO stocks during bear markets and underperform during bull markets. For stocks in the mid-cap category (Figures 3 and 4) a relationship between FO and performance is not as clear. As shown in Figure 3, midcap stock performance during the bear market (in which the Vanguard Mid Cap Index had a -9.8% return) did not reveal a clear trend in either direction. However, during the bull market (Vanguard Mid Cap Index return of 36.7%), stock performance was generally best among low FO stocks (those with FO below 15%). Midcap stocks do not show large differences in market cap across the different FO ranges. This is due, in part, to the fact that mid cap stocks are more narrowly defined in terms of market cap relative to large cap or small cap stocks. It is worth noting, though, that high FO mid cap stocks tended to have larger market cap in both the bear and bull market periods. This reveals a tendency for fund managers to favor mid (and small) cap stocks which have relatively larger market caps.

Finally, results from the analysis of small cap stocks is shown in Figures 5 and 6. Small cap stocks are well-behaved in terms of the relationship between FO and stock performance. During the bear market period (Vanguard Small Cap Index had a -19.2% return) small cap stocks with low FO (2% or below) performed the worst. The best performing small cap stocks for the one year period ending 3/31/01 were those that had FO of 16% or higher. During the bull market period (Vanguard Small Cap Index returned 35.1%), low FO stocks tended to outperform high FO stocks. Hence, as shown in Figure 6, superior bear market performance among small cap stocks is linked to higher FO. During bull markets, better performance was achieved by stocks which most fund managers shunned.

Based upon analysis of the "% Fund Ownership" figure reported for the 5,490 companies in the Morningstar's database (as of 3/31/01), it appears that companies in which a higher percentage of their stock is held by mutual funds tend to outperform during bear markets and underperform during bull markets. Popular stocks (as measured by % Fund Ownership) seem to provide a better defense against sagging markets but are not on the leading edge in surging markets. This basic relationship was most noticeable among large cap and small domestic stocks. Among mid cap stocks under-performance during the bull market was noted, but during the bear market period widely held stocks did not outperform low FO stocks.

What does all this suggest? One implication may be that stocks with high FO tend to live up to managers' expectations, even when the market sours. During booming markets, however, high FO stocks tend to provide average performance. For the bullish stock investor these results suggest a focus on stocks with low FO, whereas the bearish stock investor would seek safety among stocks with high FO. The classic axiom "there's safety in numbers" seems to apply here.

Figure 1. Fund Ownership % among Domestic Large Cap Stocks

	April 1, 2000 to March 31, 2001Bear MarketVanguard 500 Index -22.0%			April 1, 1999 to March 31, 2000Bull MarketVanguard 500 Index 17.3%
Percentage Fund Ownership (FO)	Number of Companies	One Year Average % Return	Average Market Cap($ mil)	Number of Companies	One Year Average % Return	Average Market Cap($ mil)
0% - 10%	26	4.4	42,501	35	101.9	65,160
0% - 10%	26	4.4	42,501	35	101.9	65,160
11 - 15%	50	-5.1	64,531	56	92.0	87,685
16% to 20%	61	1.0	43,062	57	117.3	39,746
21% to 25%	44	11.9	23,718	41	135.5	36,272
26 to 30%	26	20.2	22,859	15	68.6	35,439
31% and above	36	24.2	18,241	28	68.5	19,728

Figure 2. FO and Large Cap Stock Performance

Figure 3. Fund Ownership % among Domestic Mid Cap Stocks

	April 1, 2000 to March 31, 2001 Bear Market Vanguard Mid Cap Index -9.8%			April 1, 1999 to March 31, 2000 Bull Market Vanguard 500 Index 17.3%
Percentage Fund Ownership (FO)	Number of Companies	One Year Average % Return	Average Market Cap($ mil)	Number of Companies	One Year Average % Return	Average Market Cap($ mil)
0% - 5%	66	12.3	2,604	49	178.2	3,763
6% to 10%	88	17.7	2,841	75	51.9	4,231
11 - 15%	115	9.6	2,983	114	137.0	4,127
16% to 20%	104	20.9	3,123	127	77.2	4,376
21% to 25%	121	10.3	3,584	87	89.3	4,686
26 to 30%	94	11.3	3,850	94	80.7	4,429
31% and above	109	7.1	3,755	83	75.2	4,497

Figure 4. FO and Mid Cap Stock Performance

Figure 5. Fund Ownership % among Domestic Small Cap Stocks

	April 1, 2000 to March 31, 2001 Bear Market Vanguard Mid Cap Index -19.2%			April 1, 1999 to March 31, 2000 Bull Market Vanguard 500 Index 35.1%
Percentage Fund Ownership (FO)	Number of Companies	One Year Average % Return	Average Market Cap($ mil)	Number of Companies	One Year Average % Return	Average Market Cap($ mil)
0%	566	-27.1	58	492	70.0	92
1% to 2%	956	-30.8	100	962	80.5	150
3% to 5%	763	-18.9	154	811	61.7	243
6% - 10%	736	-13.8	242	839	51.9	308
11% - 15%	559	-6.8	309	621	38.8	413
16% to 20%	369	-1.3	412	415	65.1	489
31% and above	138	-2.6	547	116	54.3	701

Figure 6. FO and Small Cap Stock Performance

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