Fund Managers Move in Lockstep

As manager of the Fidelity Contrafund (FCNTX), William Danoff has compiled one of the best long-term records in the mutual fund business, gaining an annualized 8.8 percent a year over the 15 years through Sept. 3, better than 96 percent of his peer group, according to Morningstar. One key to his success: making sure his portfolio isn't just a mirror of the overall U.S. market. Recently, for example, he had almost twice as much in tech and consumer discretionary stocks as the Standard & Poor's (MHP) 500-stock index, and 19 percent of his assets in non-U.S. holdings. Yet this year, Contrafund, with $62 billion in assets, has tracked the benchmark index more closely than in any period in its four-decade history.

Danoff, who declined to comment, is not alone. Six of the 10 largest U.S. stock funds have reported correlations of 0.99 this year, according to data compiled by Bloomberg, meaning their moves almost exactly matched the S&P 500. (A correlation of 1 indicates identical movements; -1 indicates opposite swings.) Fear of another crisis prompts investors to move in and out of markets without discriminating among securities, industries, or geographies, says BlackRock (BLK) Chief Equity Strategist Robert Doll.

Correlation between assets shot up during the 2008 credit crisis, when stocks, commodities, real estate, and riskier bonds simultaneously plunged in value. All those assets rose last year in the biggest stock market rally since the 1930s and a record rebound in credit markets. Correlation has persisted in 2010 because of concerns over the European debt crisis and weaker U.S. economic growth. The attitude of investors in 2008 was "get out and ask questions later, while 2009 was all about get in and ask questions later," says Doll, who is responsible for about $500 billion in assets. "We were expecting 2010 to be the year when stock selection would add value. That hasn't been the case."

The correlation of the S&P 500 with its member stocks was 0.81 in the 50 trading days through July 7 and has since remained close to that level, according to data from Birinyi Associates, a Westport (Conn.) research and money management firm. That's almost twice the historical average of 0.45 over the past 30 years.

Mohamed El-Erian, the chief executive officer of Pimco in Newport Beach, Calif., says investors have a "risk-on/risk-off" attitude that leads to sometimes "violent" swings, such as the sell-off in markets worldwide on Aug. 11, after the Federal Reserve indicated that the economic recovery had lost momentum. "We were particularly struck by the size and correlated nature of the market moves," says El-Erian.

The increase in correlation is making it difficult for actively managed funds to produce better returns than lower-cost index funds, which seek to mimic a benchmark. Says Todd Rosenbluth, an analyst with S&P in New York: "You can't pick any mutual fund, even if it has previously been a winner, and expect it to outperform in this market."

The bottom line: With stocks moving in lockstep, it's even harder for managers to beat the market, strengthening the case for low-cost index funds.

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