The only fund to beat Nasdaq in the long term

For active managers, the math is stark. Out of thousands of funds, literally only one has beaten the Nasdaq 100 in the last five, 10 and 15 years. It was done by boiling down the stock picks to about two dozen companies and getting almost all of them into profits. The only fund that beats the Nasdaq in the long term.

Ron Baron, the 80-year-old Wall Street veteran who still manages the fund, says his secret is to combine an unwavering faith in entrepreneurs like Elon Musk with just enough paranoia to call companies in his portfolio almost every day to make sure nothing is wrong.

But Baron’s success belies the fact that for most stock pickers, beating the market index by betting big on a few names is a strategy with incredibly grim odds. That is especially true in this technology-driven era of the Magnificent Seven.

The vast majority of such efforts will probably crash and burn, according to a new paper by former New York University professor and quantum director Antti Petajisto. Why? Because the market coughs up too few winning stocks for the tactic to succeed except in rare cases.

The futility of betting against benchmarks like the Nasdaq 100 was underscored in a report last month by Bloomberg Intelligence, which was then given a public airing by investor Chamath Palihapitiya, who said the index provided superior profits “without having to do any work or diligence.” It turns out that intellect and hard work are also quite useless, thanks to the dynamics that have increasingly come to dominate the active management debate.

“Concentrated stock positions are significantly more likely to underperform than to outperform the stock market as a whole over the long term,” wrote Petajisto, currently head of equities at Brooklyn Investment Group. “Trying to gamble on identifying the few stocks with excessive returns would be a bad idea.”

Even in a US market that has increased sixfold since the global financial crisis, the number of stocks that have matched that benchmark return may be pitifully small. In fact, over the past century, the 10-year median return among the 3,000 largest U.S. stocks has lagged the broader market by 7.9 percentage points, according to the paper.

The trend may even intensify in the modern, winner-take-all economy. While the Russell 3000 is up 15 percent in 2023, the median return is about a 0.7 percent decline. A little more than half of the components are down.

In another sign of mega-cap strength, an equal-weighted version of the S&P 500 has lagged the regular value-weighted one by 12 percentage points this year, heading for its worst underperformance since 1998.

This puts active managers at a disadvantage. Squeeze the index and you can’t justify your higher fees. If you deviate from that, you risk missing out on the big gains of, say, Nvidia or Tesla.

Predictably, a larger portion of managers holding all Magnificent Seven stocks beat their benchmarks on a one-year basis, writes David Cohne, an analyst with Bloomberg Intelligence. But this was not too common: only 18% of 971 funds owned all seven names while 21% had none of them.

“Beating benchmarks, underpinned by the same seven stocks, required managers to make other random choices,” he says in a note.

Baron Capital offers a lens for active stock picking in the age of Big Tech. Its Baron Partners Fund, as Cohne found in his widely read report in August, is the only one that has beaten the almighty Nasdaq 100 over the past five, 10 and 15 years – albeit with higher volatility.

“We are buying small positions and not selling” explained Ron Baron, who has run the fund since its launch in 1992, from his office. “The process is to try to find good companies that have competitive advantages.”

Example: The fund first invested in Tesla in 2014. By 2020, it was about a third of the portfolio, Bloomberg’s data shows, eventually prompting the team to reluctantly trim its position to reassure worried clients. It has not bought any additional shares since then, but the electric car maker is now 41 percent of its long positions again. Its second largest holding is Space Exploration Technologies Corp, a private company also run by Elon Musk. The rest include everything from Charles Schwab Corp. to Marriott Vacations Worldwide Corporation.

“It may seem like we are highly concentrated because we have very few holdings, but the stocks act differently,” says Michael Baron, who runs the fund with his father.“We don’t just own high-tech, fast-growing names.”

While Finance 101 says that diversification is the only free lunch, there is some academic evidence that concentrated portfolios perform better, with some articles attributing it to the information dissemination of skilled managers.

Petajisto, who also co-invented a popular way to assess stock voters called active stocks, says managers should deviate from the index – but his previous research found that the best performers still kept their funds about as volatile as the benchmark.

A rule of thumb is that when a position exceeds 10 percent, it begins to have a meaningful effect on portfolio volatility,” he documents in his latest paper.

His findings are also a lesson in an approach common among financial advisers who mimic an index by holding a less representative sample of its shares. The pitch is that such a portfolio will move like, say, the S&P 500 without the hassle of holding all 500 names.

“You risk missing out on some of these overachievers,” Petajisto, who has a PhD in finance from the MIT Sloan School of Management, said in an interview. “It makes the game more difficult.

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