(Bloomberg Opinion) — It’s harder to make it as a professional stock picker than it used to be, which is saying a lot because it was never easy. I was reminded of this when I read that celebrated stock picker Will Danoff ended his 34-year run as Fidelity Contrafund’s solo manager earlier this month.
When Danoff took the helm at Contrafund in 1990, the measure of a US stock picker was whether they could beat the S&P 500 Index. That’s because investors had essentially two options in those days: Buy the market, usually by way of an S&P 500 index fund, or find a fund manager who can beat it.
Finding such a person has always been difficult. Few stock pickers have outpaced the market, and those who did rarely won sustainably or by a meaningful amount. Danoff accomplished both. His fund has returned 13.6% a year since September 1990 through March, including dividends, 2.8 percentage points a year better than the S&P 500. Investors rewarded his efforts with Contrafund’s $145 billion in assets.
But beating the market isn’t good enough anymore. Danoff and his new co-managers will also have to outmaneuver a growing roster of index funds that replicate stock picking strategies, including their own. Many of these funds are as cheap and easy to buy today as an S&P 500 index fund was three decades ago, except they’re more likely to be exchange-traded funds than mutual funds such as Contrafund. Whatever your preferred style of stock picking, there’s probably an index that automates it and an ETF to track it.
Index funds have a better chance of beating the market than human stock pickers because they have two key advantages. One is a lower fee drag. The cheapest index ETFs charge close to zero, so they don’t have to win by as much as higher-priced managers for that outperformance to end up in investors’ pockets. Also, unlike stock pickers, indexes have no choice but to stick to their strategy. They can’t decide to pivot when things aren’t going well, or hug the market to protect a lead, or retire after a lucky streak. Commitment to a strategy is often the difference between winning and losing.
In fact, anyone who faithfully executed Danoff’s strategy during the past three decades would have performed just as well, if not better. Fidelity describes the Contrafund’s strategy as looking for “companies with ‘best of breed’ qualities, including those with a strong competitive position, high returns on capital, solid free-cash-flow generation and management teams that are stewards of shareholder capital.”
In other words, Danoff buys high-quality companies, a widely used strategy that has been very lucrative in recent decades. Since the S&P 500 Quality Index debuted in 1995, it has posted a total return of 13.5% a year through March, 2.9 percentage points a year better than the S&P 500 and 0.9 percentage point a year better than Contrafund. If you add back Contrafund’s expense ratio of roughly 0.6 percentage point, Danoff’s performance before fees nearly matches that of the quality index.
Investors couldn’t buy a fund that tracks a quality index in 1990, but there’s no shortage of them now. That includes a Fidelity ETF that follows the Fidelity U.S. Quality Factor Index and charges a quarter as much as Contrafund.
Danoff has outpaced Fidelity’s quality ETF since the fund’s inception in 2016. Longer term, though, the two funds’ performance before fees should be similar because their portfolios are nearly identical, according to Morningstar’s numbers. That includes the median profitability of the companies they own, as measured by net margin and return on capital, as well as their median valuation based on price relative to sales and earnings. After fees, Fidelity’s ETF has a clear edge. It’s also likely to be more tax-efficient because ETFs, unlike mutual funds, don’t distribute capital gains to investors.
Danoff isn’t the first star manager at Fidelity who was fortunate to mine the right strategy at the right time. Peter Lynch is widely hailed for outpacing the S&P 500 by more than 13 percentage points a year from 1977 to 1990. He favored buying high-quality companies at a reasonable price, a blend of quality and value strategies. It happened that both value and quality paid unusually large premiums relative to the market during that period. An equal blend of the two strategies would have performed nearly as well as Lynch’s Magellan Fund.
Of course, there’s no guarantee that any of these stock-picking strategies will continue to beat the market, regardless of who attempts it. If anything, the proliferation of index ETFs deploying these strategies is likely to make them less lucrative.
In that sense, the choice for investors is still the same: Buy the market or try to beat it. The difference is that index funds now do both cheaply and systematically, and therefore more reliably. That means stock pickers like Danoff and his team will have to do better than beat the market — they’ll have to beat clones of themselves.
To contact the author of this story:
Nir Kaissar at [email protected]