The landscape of the American technology stock market has undergone a remarkable transformation over the last decade, with the so-called "Magnificent Seven"—comprised of tech giants such as Apple, Microsoft, and Google—emerging as true titans, producing staggering returns that outstrip traditional investments like the S&P 500. Yet, amidst this tech-driven surge, a perplexing phenomenon arises: why have active mutual funds in the U.S., which traditionally lean towards growth sectors, largely avoided pouring money into tech stocks? More intriguingly, these funds even struggle to match the performance of the benchmark index itself.
In a recent report released by Western Securities, the research underscores several critical reasons why U.Sactive equity funds have not clustered around technology stocks, despite their phenomenal performanceThe first major point noted is that even if funds were to focus heavily on technology stocks, the resultant performance would not guarantee superiority over index returns
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In fact, only a minuscule 1% of funds, which embarked on an extreme overweight positioning, managed to beat the performance of the S&P 500.
Another pivotal consideration is that tech stocks, while profitable over the long haul, come with significant volatilityFor instance, during extended holding periods, portfolios could experience severe drawdowns of over 50% for nearly 700 days—a reality that tests the psychological endurance of investorsMany cannot withstand such drastic fluctuations and end up selling at a loss.
Moreover, the volatility among the Magnificent Seven stocks compounds the difficulty in achieving optimal investment timingBetween 2010 and 2012, for example, when Apple outperformed the S&P 500 significantly, NVIDIA lagged behindThis pattern reversed from 2013 to 2016, where NVIDIA took the lead while Apple falteredSuch periods of rotation make it exceedingly challenging for investors to identify the most opportune moments to enter or exit the market
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Hence, achieving overweight positions in technology stocks is no simple feat.
Additionally, the transparency of U.Spublic mutual funds presents another layer of complexitySince all positions held by these funds are publicly disclosed, savvy investors can quickly uncover the holdings and find corresponding passive index products to invest inThe proliferation of diverse fund products, especially low-cost ETFs, amplifies this trend, as investors prefer the tax advantages and reduced fees of passive investment vehicles over active management fees, which tend to be higher.
Since 2010, technology stocks have enjoyed a remarkable bull run and have outperformed the S&P 500 total return index by a wide margin, with average annualized returns of 32.7% and an excess return of 17.5%. Yet, paradoxically, outperforming the index as an active fund amidst this long tech bull run has proven increasingly difficult.
Western Securities' analysis paints a stark picture: less than 30% of active equity funds have been able to outpace the S&P 500 total return index over the past ten years
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Looking back, aside from 2010 and 2022, almost all years since 2008 show negative excess returns compared to the S&P 500 for active fundsEven when considering longer holding periods, the statistics do not favor these fundsThe rolling excess returns over three and five years demonstrate that for a nearly entire decade, only 17.2% of funds achieved positive excess returns when adjusted for CAPM alpha and FF5 alpha, suggesting that randomly purchasing an active equity fund is likely to yield inferior returns compared to a simple investment in an S&P 500 ETF.
Despite tech stocks being the dominant theme, the allocation ratios in active equity funds did not reflect a corresponding overweight scenarioIn fact, data from the past decade illustrates that the proportion of tech investments among active funds typically trails behind that of Vanguard’s S&P 500 ETFThis trend has intensified post-2020, indicating that even as tech stocks soared during the pandemic, many active funds opted to decrease their tech positions.
Emerging from these data points, roughly 25% of active mutual funds held larger positions in tech stocks compared to the S&P 500 ETF
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However, when defining a significant overweight as a 40% or greater allocation to the tech sector, the corresponding funds fall below 10%. Recent Q3 disclosures revealed that only about one-third of active equity funds held positions in the Magnificent Seven, with just 24.5% of those overweighting themFurthermore, only 8.5% of all active funds displayed non-underweight positions in these tech champions.
The reluctance to overweight technology stocks can largely be attributed to the challenges of outperforming the index even if they do soThe stark reality is that only a mere 1% of funds that significantly concentrated their investments in tech managed to eclipse the S&P 500 performanceThese top-performing funds maintain an average tech allocation of 81.3%, significantly higher than the S&P average of 32.34%. This stark disparity illustrates that even increased concentrations in tech do not guarantee superior returns
Notably, the volatility and corresponding higher drawdowns further impede the performance relative to the benchmark, leading to lower Sharpe ratios.
The high fluctuation of the Magnificent Seven stocks reflects another layer of investment complexity and riskTheir combined performance, though collectively superior to the S&P 500, showcases multiple instances of dramatic pullbacksFor instance, the cumulative excess return net value experienced maximum declines ranging from -73.2% to -34.7%. Furthermore, the average drawdown stretches to about 53.7%, with durations of loss lasting from 282 to 1106 daysThis exposure to protracted periods of detractions amplifies risks for investors; enduring drawdowns exceeding 50% could span roughly 700 days, presenting a significant mental barrier for those reluctant to hold through such turbulent phases.
The swift rotation amongst the Magnificent Seven is yet another impediment to consistent investment success
Different stocks exhibit dissimilar performance trajectories, limiting the predictability for market participantsBetween 2010 and 2012, for instance, while Google, Microsoft, and NVIDIA underperformed the benchmark, Apple consistently excelled, achieving returns surpassing the S&P 500 by more than 15%. This trend reversed in subsequent years, adding another layer of difficulty for investors attempting to capitalize on tech stock investments consistentlySince 2022, only a select number of stocks within this elite group have generated gains that surpass the S&P 500, illustrating that tech investment remains a precarious endeavor.
Altogether, the challenges faced by U.Sactive equity funds in navigating the technology sector serve as a microcosm of the broader investment landscapeTo achieve long-term, sustained, and considerable outperformance over the S&P 500 total return index through investments in tech or the Magnificent Seven, funds would need to strike the right balance between concentration and diversification
However, engaging in such concentrated strategies may inadvertently expose them to a new array of risks.
In view of this, a pertinent question arises: if investors were to commit to significant long-term allocations towards these technology stocks, why wouldn’t they simply pivot towards lower-cost ETFs that provide easy access to high-performing tech exposure? The U.Sfund market boasts a diverse array of products, with well-informed investors generally seeking lower fees for superior investment outcomesThe magnitude of publicly disclosed holdings allows them to scout out passive investment opportunities swiftly, consequently diminishing the attractiveness of active fund strategies.
Presently, some of the most significant ETFs tracking technology themes have emerged, notably State Street's XLK and Vanguard's VGT, with expense ratios ranging from a mere 5 to 9 basis points