Due to a few stocks accounting for most of the market returns, having a diversified investment portfolio may actually lower returns.

This time should be different. It will be a stock picker's market, and smart active investors will no longer lag behind the index and will be able to demonstrate their abilities. However, active management continues to underperform.

Supporters of the Efficient Market Theory argue that most managers are unable to outperform the market. However, there is a disregarded structural issue that is leading to the failure of active managers: we are currently in a period of a "narrow market" where a few stocks - known as the "big seven" - dominate. $Apple (AAPL.US)$and$Microsoft (MSFT.US)$Please use your Futubull account to access the feature.$Alphabet-A (GOOGL.US)$N/A.$Amazon (AMZN.US)$and$NVIDIA (NVDA.US)$N/A.$Meta Platforms (META.US)$And.$Tesla (TSLA.US)$- Occupies the majority of market profits. Therefore, any manager who has established a well-diversified investment portfolio will inevitably underperform, as holding stocks other than the "Big Seven" will drag down performance.

According to Morningstar data, in the first half of 2024, only 18.2% of actively-managed mutual funds and market-cap weighted S&P 500 index-based exchange-traded funds (ETFs) outperformed the index. This proportion is lower than the 19.8% in 2023. Over the past decade, only 27.1% of actively-managed funds benchmarked against the S&P 500 managed to outperform the index on an annual average basis.

In the first half of this year, the prospects for active managers were particularly limited as the "Big Seven" accounted for nearly 60% of the total return of the S&P 500 index. These seven stocks also accounted for over half of the performance of the S&P 500 in 2023. Their extraordinary performance means that they now represent approximately 30% of the total market capitalization of the S&P 500. The New Yorker, a biweekly magazine, called this the "highest concentration of capital among the smallest number of companies in the history of the U.S. stock market."

If you operate a concentrated investment portfolio and hold all seven stocks, you will be very successful. But most managers have a diversified investment portfolio, where no individual stock typically occupies more than 5% of the portfolio. This means that if you manage to obtain the allocation of all seven 'giants' through intelligence or luck, it will only account for 35% of your investment portfolio (7 stocks multiplied by 5%). The remaining 65% must consist of underperforming stocks, many of which will drag down the overall performance.

You might say that these are the circumstances of the first half of 2024; since then, the "Big Seven" has cooled down slightly, and in a normal market, managers have a better chance of making accurate judgments. But the truth is, a normal market often tends to be a narrow market. Before the "Big Seven," there were the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google). In 2017, the average return of these five stocks was close to 50%, while the return of the S&P 500 was 21.8%. The FAANG stocks accounted for over 10% of the market capitalization of the S&P 500 and contributed 4.3 percentage points to the overall market return in 2017. By 2020, the market cap of the FAANG stocks had soared to 20% of the total index market cap, reaching the highest level of concentration in the history of the S&P 500.$Netflix (NFLX.US)$Meta Platforms) have occupied the majority of market profits. Therefore, any manager who has established a well-diversified investment portfolio will inevitably underperform, as holding stocks other than the "Big Seven" will drag down performance.

Before the "big seven" and FAANG, there were also "The Four Horsemen" in the late 1990s narrow market - Microsoft, $Cisco (CSCO.US)$,$Oracle (ORCL.US)$and $Intel (INTC.US)$ - leading the market up in the 1990s technology boom. In 1999, these four were joined by $Dell Technologies (DELL.US)$Accounting for around 42% of the total market cap increase of all 500 companies. Looking back over half a century, despite thousands of listed stocks, a few stocks like Sears Holdings Corp, Eastman Kodak, and Polaroid from the 'Nifty Fifty' generated disproportionate returns.

The widespread existence of narrow markets suggests that constructing a typical institutional investment portfolio consisting of 80 to 100 stocks may inevitably reduce rather than enhance returns. However, most managers know that they need to offer a widely diversified portfolio with dozens of names because a 'concentrated portfolio' is considered too risky for most investors.

Some active managers are infamous for 'invisible indexing' - building investment portfolios that are almost identical to the S&P 500, ensuring that the results do not deviate too much from the benchmark. But how do you construct an invisible narrow market portfolio? You can offer a concentrated investment portfolio consisting of 25 stocks and perform well if you have most of the 'seven giants' stocks or the 'elephant' stocks of that time. But this comes with significant market risk - and significant marketing risk.

In short, as long as the market is narrow, stock pickers face a daunting task.

Editor/Somer