Tale of the Tape

he performance parameters of individual stocks are vastly different from those of the indexes they comprise. So gauging the performance of the U.S. equity market by tracking the performance of prominent indexes alone can provide of distorted view your clients' portfolios. What's more, a large percentage of large-cap domestic equity fund managers manage to the index in an attempt to minimize "tracking error" and meet their benchmark. As a result, there is high degree of redundancy in the performance of large-cap funds. This article will compare the performance of individual U.S. stocks vs. equity funds, to help advisors make the best possible stock and fund selections for their clients' portfolios.

A Good Year for the Market

The U.S. equity market in 2006 was very rewarding, especially for individual securities (see "Individual Equities"). In fact, nearly three-quarters of the 6,133 stocks listed in Morningstar Principia for the year enjoyed a positive one-year return. The average equal-weighted return for the 3,719 stocks with a positive return was 48.7%, while the median positive return was 25.2%. The best performing stock in 2006 (CIC Holding Company) had a return of 2,208%.

Even during a relatively robust year for equities-as gauged by average return, median return and the return of the major U.S. equity indexes (see "Equity Index Lineup")-a significant number of U.S. companies had negative returns. There were 2,414 U.S. stocks that had a negative return in 2006, and their average equal-weighted return was -30.5%. The median negative return was -23.2%. What's more, 562 stocks (or just over 9% of all 6,133 companies) suffered a 2006 return of -50% or worse. The average number of shares outstanding among those 562 companies was 60 million. Eighty stocks in the Principia database-just over 1% of the total-had a one-year return of -90% or worse in 2006.

The Long View

Over the 3-year period ending Dec. 31, 2006, the mean equal-weighted annualized return of the 5,573 individual stocks that survived the entire 36-month period was 6.3%. The median 3-year annualized return of those 5,573 stocks was 7.3%. Of those 5,573 stocks there were 2,095 (37.6%) that had a negative three-year average return. The average negative return was a discouraging -25.4%. Among the 3,478 stocks that had a positive three-year annualized return, the average return was 25.3%.

Nearly one-third of the 5,214 stocks that survived the entire 5-year period ending Dec. 31, 2006 had a negative five-year annualized return. The average negative return was -23.7%. The average five-year annualized return for the 67% of stocks that enjoyed a positive return was just over 21%. One stock (J.L. Halsey) had a five-year annualized return of 201%. On the other end of the spectrum, one stock (MB Tech) had a five-year annualized return of -91.8%.

Over the 10-year period ending on Dec. 31, 2006, the average return of the 3,626 stocks that survived the entire period was a mere 3.2%. The impact of 2000-2002 is clearly evident in that figure. The median 10-year annualized return was 7.7%. A median 10-year annualized return that is higher than the 10-year mean is a reminder that there were some very large losses produced during the 2000-2002 meltdown. For example, during that period, 206 stocks had a 10-year annualized return of 25% or higher. But 315 stocks had a 10-year annualized return of -25% or worse. The highest 10-year annualized return among U.S. stocks was 73.9% (Hansen Natural). Amazingly, there were 68 out of the 3,626 stocks (or about 2% of the group) that survived the entire period and had an average annualized 10-year return of -50% or worse.

How Mutual Funds Performed

Next, we examine U.S. equity mutual funds (see "U.S. Equity Funds"). There were 2,637 U.S. equity funds that survived the entire year of 2006. Only domestic equity funds with at least 12 months of performance as of 12/31/2006 were included. Furthermore, funds with more than 15% of their portfolios in cash, bonds or non-U.S. stock were removed from the study. Redundant share classes were also omitted. This allows for a sensible comparison with the performance results of individual U.S. stocks.

The mean equal-weighted one-year return of U.S. equity funds in 2006 was 13.2%, while the median return was 13.4%. The asset-weighted one-year return (my own calculation) was 14.4%, which suggests that larger funds tended to perform slightly better-or that, by year-end, the better performing funds had attracted proportionally more assets. For the asset-weighted equity fund return, each fund's one-year return is weighted according to the proportion of each fund's assets, compared to the $3.1 trillion total assets managed by the entire group of 2,637 funds.

For example, the largest U.S. equity fund included in this data set was Vanguard Index 500, with total net assets of $118.5 billion. Total net assets (among all share classes) for all 2,637 funds summed to $3.1 trillion. Therefore, Vanguard 500's percentage of the total U.S. equity fund asset base was 3.822%. To determine the Vanguard 500's asset-weighted return, the fund's 15.64% return was multiplied by .03822. This number represents the contribution of Vanguard 500 toward the total asset-weighted return of all 2,637 funds. In other words, multiplying the one-year return of each fund (in decimal form) by its percentage of the total assets yields a "figure". All 2,637 "figures" are then summed to produce the asset-weighted return of the 2,637 funds. This process was repeated for all 2,637 funds to determine the total asset-weighted return of U.S. equity funds in 2006.

Only 55 funds-just over 2% of the group-had a negative one-year return in 2006. The average negative return of those 55 funds was only -2.4%, while the average return of the 98% of funds with a positive return was 13.5%. The best U.S. equity fund in 2006 generated a total return of 39.5% (First American Real Estate Securities Y) while the worst performing fund lost 9.3% (Live Oak Health Sciences).

Over 99% of the U.S. equity mutual funds in this analysis had a positive three-year equal-weighted annualized return as of year-end 2006. The mean three-year annualized return of the 2,274 funds surviving the entire three-year period was 11.1%, and the median return was 10.8%. The highest three-year annualized return was 31.7% (Fidelity Select Energy) and the worst return was -8.4% (Van Wagoner Growth Opportunities).

The average five-year annualized return for the 2,025 funds that survived the entire period was 7.5%. The returns over this time frame were lower because 2002 was such a rough year for U.S. equities. Nevertheless, nearly 96% of the funds had a positive five-year annualized return (which averaged 8.0%). The average return among the 84 funds that had a negative 5-year annualized return was -1.9%.

There were 1,059 funds that survived the entire 10-year period. The mean 10-year annualized return was 8.8%, just slightly better than the median return of 8.5%. The best return was 21.8% (Bridgeway Ultra-Small Company), while one fund managed to generate a 10-year annualized return of -5.4% (American Growth D). Of the 1,059 funds, only 6 had a negative annualized return over the 10-year period and the average of those 6 funds was -2.2%.

Conclusions

The results of this analysis reinforce two important axioms: First, the parameters of individual stock performance are much wider than those of equity fund performance. In any given year, the best return and worst return of a single stock will always exceed the best return and worst return of a mutual fund. Second, there are some periods when the portfolio effect (theoretically achieved within a mutual fund) can actually magnify the number of funds that experience a loss. This can occur when a high percentage of stocks that are widely-held by mutual funds perform badly.

Generally speaking, a much smaller percentage of mutual funds have negative returns than individual stocks. Over the past eight years, the median percentage of stocks with a negative one-year return was 50%. Among U.S. equity mutual funds, the median percentage with a negative one-year return was 10%. Nevertheless, in 2001 and 2002 more mutual funds than individual stocks had negative returns, as shown in "Changing Places". Why? Because a high percentage of widely-held stocks performed badly in 2001 and 2002. As a result, an unusually high percentage of mutual funds had a negative return. There is little protection in a portfolio in which most of the stocks do poorly. Too many funds shopping in the same store.

In defense of diversification and long-term horizons, the mean U.S. equity mutual fund return over the past three, five, and 10-year periods exceeds the mean return of individual stocks. Interestingly, the percentage of U.S. stocks that have a negative return over those time periods is consistently in the range of 31%-39%. By comparison, the percentage of U.S. equity funds with a negative return is dramatically lower (2.1% over one year, 0.7% over three years, 4.1% over five years and 0.6% over 10 years). Of course, some mutual funds with long-term poor performance closed; but the impact of survivor bias is relatively minor.

But in 2002 (the starting year of the five-year period ending in 2006) the performance of U.S. equity mutual funds was horrific, with 97.1% of them having a negative one-year return compared to only 63% of U.S. stocks. This is a reminder that many U.S. equity mutual funds-particularly large cap funds-own many of the same large cap stocks. When those similar holdings perform badly (e.g., 2000, 2001, 2002) a lot of mutual funds perform poorly.

There is a practical implication to this observation: it is more likely for overlap to occur among large cap funds than small-cap funds because there are only a few hundred large cap stocks in the U.S. market. Of the 6,133 U.S. stocks with a one-year return as of Dec. 31, 2006 in Morningstar's database, only 300 were classified as large-caps. (For the record, 780 were mid-caps, 4,677 small caps, and 376 were not assigned a style-box classification, but likely fall into the small/micro cap category.) Therefore, when selecting large cap funds for inclusion in a portfolio, it is more important to screen for redundant holdings than it is when combining several small cap funds.

What Indexes Don't Reveal

In conclusion, I'd like to make a brief comment about the use of equity indexes to gauge the performance of the U.S. equity market. As shown in "Equity Index Lineup", 1999 was a banner year for equities-if you judge by the performance of prominent indexes. Nevertheless, of the 6,242 individual stocks on the market in 1999, more than 50% (3,384) had a negative return that year, as shown in "Changing Places". The average negative one-year return among those 3,384 stocks was -29.7% and the median negative return was -25.7%. Despite the rosy picture painted by the indexes, 1999 was a very rough year for thousands of U.S. stocks.

In 1999, only about 10% of U.S. equity mutual funds had a negative return. Is it because the vast majority of mutual fund managers were savvy shoppers? Not likely. In 1999, widely held large-cap stocks performed well. And since a large percentage of U.S. equity mutual funds invest in widely held large-cap stocks, mutual funds as a whole did well.

Fast forward to 2002. All the major U.S. equity indexes register a meltdown. And yet, the percentage of U.S. stocks that had a negative one-year return was not dramatically higher than in 1999 (54% in 1999 vs. 63% in 2002). Nevertheless, over 97% of U.S. equity mutual funds tanked in 2002. The average negative return was -23.6%, and the median negative return was -22.7%. Think 1999 in reverse: The performance of widely held large-cap stocks was very poor in 2002, and so was the performance of the vast majority of mutual funds.

More recently, 2005 was another rough year for U.S. equities, with more than 50% of the 6,091 stocks registering a negative return. The average negative return among the 3,199 stocks that faltered was -30.6%, and the median negative return was -22.7%. Likewise, the performance of the U.S. equity indexes in 2005 registered only modest returns: the S&P 500 at 4.9%, the Russell 3000 at 6.1%. However, U.S. equity mutual funds had a solid year in 2005. Only 162 funds (6.4% of the 2,536 funds) had a negative return in 2005, and the average negative return was a mere -3.7%. The overall average return for all 2,536 distinct U.S. equity funds in 2005 was 6.95%-better than that of any of the major equity indexes.

The key difference between 2002 and 2005 was the performance of large-cap stocks. In 2002, the average one-year equal-weighted return of the largest 500 U.S. stocks (as measured by outstanding shares) was -24.99% (-21.1% was the median return). Those 500 stocks represented 68% of all shares outstanding among all 6,004 stocks. The return of the S&P 500 in 2002 was comparable at -22.1%. Moreover, the mean return of all 6,004 stocks was -11.5% and the median return was -14.4%, indicating that the U.S. equity market was weak from top to bottom (as demonstrated by the negative returns of all the major equity indexes). However, large-caps performed far worse than the broad equity market in 2002.

It is clear that as U.S. large cap stocks go, so goes the performance of a large percentage of U.S. equity mutual funds. Recall that over half of all U.S. equity mutual funds are classified as large-cap funds despite the fact that large-cap U.S. stocks comprise only about 5% of U.S. equities. As a result, finding large cap equity funds that have low correlation to each other can be more challenging than finding distinctly different mid-cap and small-cap funds. Therefore, when selecting large cap funds for inclusion in a portfolio it is more important to screen for redundancy in the holdings of each large cap fund than it is to screen for redundancy when combining several small cap funds in a portfolio.

These results serve as a reminder that measuring the performance of the U.S. equity market is not a simple task. It is clearly a matter of perspective. We see what we choose to measure. And all too often that amounts to seeing only the tip of the market.

Individual Equities

U.S. Stocks as of December 31, 2006	1 Year	3 Years	5 Years	10 Years
Number of Stocks Surviving the Entire Period	6,133	5,573	5,214	3,626
Mean Equal-Weighted Annualized Return (%)	17.5	6.3	6.6	3.2
Median Annualized Return (%)	8.4	7.3	9.4	7.7
Share-weighted Annualized Return (%)	18.5	-----	-----	-----
Maximum Return (%)	2,208	753	201	73.9
Minimum Return (%)	-99.9	-93.9	-91.8	-76.8
Average Positive Return	48.7	25.3	21.3	13.0
Average Negative Return	-30.5	-25.4	-23.7	-18.1
Percentage of Stocks with Negative Return (%)	39.4	37.6	32.7	31.3

Sources: Morningstar Principia raw data, author research                                                 

U.S. Equity Funds

Sources: Morningstar Principia raw data, author research

Changing Places

Equity Index Lineup

Major U.S. Equity Indexes	1999	2000	2001	2002	2003	2004	2005	2006
DJIA	27.2	-4.9	-5.4	-15.0	28.3	5.3	1.7	19.1
S&P 100	32.8	-12.6	-13.8	-22.6	26.2	6.4	1.4	18.5
S&P 500	21.0	-9.1	-11.9	-22.1	28.7	10.9	4.9	15.8
Russell 1000	20.9	-7.8	-12.5	-21.7	29.9	11.4	6.3	15.5
Russell 2000	21.3	-3.0	2.5	-20.5	47.3	18.3	4.6	18.4
Russell 3000	20.9	-7.5	-11.5	-21.5	31.1	12.0	6.1	15.7
DJ Wilshire 5000 (cap-weighted)	23.6	-10.9	-11.0	-20.9	31.6	12.5	6.3	16.0
DJ Wilshire 5000 (equal-weighted)	38.4	-7.5	27.9	-9.5	91.8	28.9	5.5	18.9

Source: Morningstar Principia raw data.

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Craig L. Israelsen, Ph.D. is an associate professor at Brigham Young University. He teaches family finance in the Department of Home and Family Living. His research interests include mutual fund analysis. He writes monthly for Financial Planning magazine. Learn more about Craig Israelsen at http://familyliving.familylife.byu.edu/faculty/israelsen.htm