Obscured by an Index

hat a difference one year can make. As shown in Figure 1, the 5 and 10 year annualized returns of major equity indices took quite a beating during 2001. Both the DJIA and the S&P 500 had their 5 year annualized returns knocked down by about 40% compared to the 5 year average annualized return at year-end 2000. Midcap stocks, as measured by the S&P Midcap 400 Index, lost ground during 2001, but fared better than large caps. The S&P Midcap index's 5 year annualized return fell by 21% as a result of 2001. The Russell 2000 Index, a small cap barometer, was one of the relatively few domestic equity indices to generate a positive return in 2001. Nevertheless, the Russell 2000 had its five year annualized return fall by over 27% compared to one year earlier. So, as most everyone who follows equity markets already knows, 2001 was only slightly more enjoyable than a bike accident.

However, as is generally the case, one's perception of "how the market is doing" is heavily dependent upon which specific index is being used to measure "the market". For instance, the DJIA did considerably better than the S&P 500. While both are considered to be large cap indexes, they certainly do not move in lock-step.

Figure 1. Historical Returns of Major Equity Indexes

The moving targets we call "annualized return" are indeed susceptible to gyrations in the equities market, despite the fact that measuring performance over multi-year periods attempts to dampen out the bumps and dips of short term performance. As a result, equity benchmark indices - as useful as they are - sometimes hide as much, or more, than they reveal. This article attempts to reveal some of the hidden performance of equities, both among individual stocks and equity mutual funds during the year 2001, and over longer periods as well.

One method for comparing, and revealing, the performance of individual stocks and equity mutual funds beyond what benchmark indices provide is presented in Figure 2. Only companies (i.e. stocks) which are U.S.-based and had at least 12 months of performance history were included in the analysis. The selection criteria for mutual funds eliminated those with less than 12 months of performance and those with more than 15% of their portfolios in either cash, bonds, or non-U.S. stock. Redundant funds were also omitted (i.e. only "Distinct Portfolios" were selected). Data used in this analysis were extracted from Morningstar Principia Pro.

As shown in Figure 2, there were 6,197 stocks in existence for the full year between January 1, 2001 and December 31, 2001. The arithmetic 1 year mean return for this group of stocks was 18.1%, while the median return was 3.5 percent. Both figures are sizably different from the S&P 500 one year return of -11.9%. Perhaps the most poignant statistic is that during 2001 47% of domestic stocks had a negative one year return.

The difference between the mean and median return over the one year period suggests an upward bias produced by stocks which had a one year return in excess of 100%. Inasmuch as a stock cannot lose more than 100% there is a limit on the size of a negative return. There is, however, no such limit on positive returns, hence there can be an upward bias in mean return compared to median return. This upward bias is particularly noticeable in shorter time frames (e.g. one year or less). In fact, there were 573 stocks which had a one year return in excess of 100% during 2001. The highest reported return among individual stocks was 2,492% and the lowest return was -99.9%.

Understandably, Standard & Poor's does not purport the 500 Index to be a complete picture of the U.S. equity market. And this is precisely the point here: no single equity index can possibly provide an accurate gauge of the entire U.S. equity market. Case in point: Among the four indices shown in Figure 1 the return for 2001 ranges from -11.9% to 2.5%. As an aside, perhaps this is why not all clients get upset simultaneously when the "market" sours. They each have a potentially unique slice of the "market" which may be performing quite differently from the broad market indexes. In the final analysis, people don't care as much about what is happening in general as compared to what is happening to them specifically.

A revealing statistic is the "share-weighted" return. This figure is not generated by Morningstar. The share-weighted return (as calculated by the author) assigns a greater weight to stocks which have more shares outstanding and less weight to thinly held stocks. For instance, General Electric had the largest amount of shares outstanding within the Morningstar database as of December 31, 2001. In fact, of the 454 billion total shares outstanding, GE had 9.9 billion, or 2.18% of the total. Therefore, the 2001 return for GE (-15.07%) was multiplied by .0218. This same calculation procedure was applied to all 6,197 stocks, resulting in a share-weighted average return of -3.1%. Recall that the raw average one year return for all stocks was 18.1%. The share-weighting procedure brings the return of all 6,197 stocks closer to the -11.9% return of the S&P 500, arguably the predominant benchmark of the U.S. equity market. Not surprisingly, the S&P 500 Index is a market-cap weighted index, a technique which has the same basic effect as share-weighting the returns of individual stocks.

That the share-weighted average return is lower than the raw average return of stocks implies that widely owned (i.e. larger) companies performed worse relative to companies with less stock outstanding (i.e. smaller firms). In fact, the average one year return of the 200 largest (i.e. most shares outstanding) companies was -12.7%, even worse than the S&P 500 Index. The largest 200 companies represent only 3.2% of all 6,197 stocks, yet account for 53.2% of all outstanding shares of domestic stock. The smallest 200 stocks had an average return in 2001 of 18.2%.

Obviously, when widely owned firms (e.g. General Electric, Cisco Systems, ExxonMobil, Intel, Pfizer, Oracle, Microsoft, Citigroup, Wal-Mart, AOL Time Warner, etc.) do poorly, more investors are affected. The U.S. equity market is one in which a small percentage of companies account for a disproportionately large portion of total outstanding shares of stock. For this reason, the share-weighted average return is a more accurate reflection of what happens among real investors compared to a simple arithmetic mean return for all stocks. The share-weighted return was calculated for the one year period only, inasmuch as the number of a companies shares outstanding at one point in time (e.g. 12/31/01) cannot reliably be applied to performance data over a period beyond one year.

Over five years, the picture provided by the indices and the aggregate return of all stocks diverges dramatically. The four U.S. indices show 5 year annualized returns (as of 12/31/01) ranging from 7.5% to 16.1%, whereas the raw average return for the 4,577 stocks in existence over the entire five year period was -1.9%. The median return for all stocks over 5 years was a paltry 2.3 percent. Moreover, 45% of all stocks had a negative 5 year average annualized return. This probably comes as a genuine surprise to those who only focus on the performance of the prominent equity indices. Over 10 years, the four indices paint very nice annualized return pictures, yet 26% of the 2,410 stocks which were in existence over the entire period experienced a negative 10 year annualized return.

Also shown in Figure 2 are the performance data of U.S. equity mutual funds as of December 31, 2001. It is somewhat startling to note that a higher percentage of mutual funds (77%) had a negative one year return relative to individual stocks (47%). Typically the diversification effect within a mutual fund portfolio prevents this from happening. However, because mutual fund managers own many of the same stocks (e.g. hot companies) these same funds get hammered when the hot stocks cool off. Such was clearly the case during the 2001. Moreover, the majority of equity mutual fund assets reside in large cap funds - and large cap stocks took a beating in 2001. Over longer periods of time, mutual funds tend to insulate investors from loss more effectively than a random sample of individual stocks. For instance, over 5 years only four percent of equity funds had a negative annualized return compared to 45% of individual stocks. Over the 10 year period, no equity funds had a negative annualized 10 year return. Survivorship bias is clearly involved here, but would obviously apply to stocks as well as funds.

Over the one year period, U.S.-based equity funds had an average return of -10.9%. When weighting the returns by amount of net assets (comparable to the share-weighting procedure used for stocks) the net asset weighted average return worsens to -11.8%. In other words, big funds stumbled a bit more than average-sized and small funds. This reminds us that large funds tend to own large stocks, which in 2001, hurt performance. As a side note, there is a vastly uneven distribution of assets among domestic equity funds. The largest 100 equity funds (just over 4% of the total sample of 2,317 U.S. equity funds) held $1.016 trillion in assets, or nearly 61% of the $1.676 trillion in domestic fund assets held by the 2,317 funds as of 12/31/01. (Recall that this analysis has removed redundant funds, hence the total asset figures do not represent the entire domestic fund universe). So, as is the case with individual stocks, when widely held funds falter, a disproportionately large number of investors are affected. Calculating the net asset weighted return is one way of demonstrating this.

When comparing performance between funds and stocks a striking contrast emerges over the 5 year period. As of 12/31/01 the average equity fund produced an annualized return of 9.5% compared to -1.9% for the average individual stock. The difference among median 5 year returns is also very large (2.3% for stocks versus 9.6% for equity funds). Clearly, as shown by maximum and minimum return data, extremes in performance (both up and down) are characteristic of individual stocks. Mutual funds tend to perform within more narrow performance parameters. Compared to individual stock, mutual funds will always have maximum returns which are lower and minimum returns which are higher over virtually any time period. The 5 year period is a clear example of this. The parameters of 5 year stock performance were from -87.5% to 126.8 percent, whereas the worst fund lost 26.2% on an annualized basis and the best fund had an annual return of 35.0 percent.

Over a ten year period, the performance of individual stocks and funds begins to coalesce. The median return for 2,410 individual stocks was 9.2% and for 639 funds it was 11.7%. But, as previously noted, 26% of individual stocks had a negative 10 year annualized return while no equity funds dipped below zero. In fact, only 11 funds out of 639 had an annualized return of less than 5% over the ten year period.

It would undoubtably be helpful to remind clients that mutual funds are not the most exciting approach to investing. In terms of performance, they will never compete with the most successful single issues of stock in the short or long run. However, over the longer run, the vast majority of surviving equity mutual funds produce a positive return - not as often the case among surviving individual stocks.

Figure 2. Individual U.S. Stocks vs U.S. Equity Mutual Funds (as of 12/31/01)

U.S.-Based Stocks

U.S. Equity Mutual Funds