Goldman Sachs: Why Stock Pickers Have Suffered a Really Bad Year

Professional stock pickers have had a terrible 2014.

With Labor Day in the rear view mirror and less than four months remaining in 2014, Goldman Sachs Group Inc -0.18% . takes a moment to examine how fund managers have fared so far and evaluate the circumstances they face for the rest of the year.

It isn’t a pretty picture, but Goldman says that may actually bode well for the market through the rest of the year.

Only 23% of large-cap mutual fund managers have outperformed the S&P 500this year, rivaling the worst performance in the past decade, according to David Kostin, chief U.S. equity strategist at Goldman. By comparison, about 37% of fund managers have outperformed the benchmark since 2003. Only performances in 2006, 2010 and 2011 have been as bad or worse than the current year’s pace.

Most large-cap fund managers “will be forced to re-evaluate their portfolios or embrace the likelihood of drafting very disappointing year-end letters,” Mr. Kostin said.

The performance figures are somewhat surprising, especially since stocks are no longer moving in lockstep with global economic developments. Correlations between individual stocks in the S&P 500 have fallen to pre-financial-crisis levels, which theoretically should make it easier for active money managers to separate the winners from the losers.

But that hasn’t taken shape this year amid a choppy rally that has suffered through fits and starts. Stocks hailing from the biotechnology, social media and Internet sectors–otherwise known as momentum stocks–rallied at the beginning of the year, fell sharply from March through May and have mainly been rebounding ever since. Other sectors, such as small-cap stocks, have struggled even as the broad market has rallied.

Other stock pickers are also struggling in the current environment. Fewer than 20% of large-cap growth and value managers have outperformed their respectiveRussell 1000 benchmarks, according to Goldman. Hedge funds have also woefully underperformed. The average hedge fund is up just 2% this year, according to industry tracker HFR, compared to about a 10% return, including dividends, for the S&P 500.

“Choice of shorts and market timing are the clear sources of blame,” Mr. Kostin said.

Amid the bleak returns, there is some good news for the broad market. Based on the underperformance of most types of professional stock pickers, Goldman says the S&P 500 should keep rallying through the end of the year. That’s because many of these funds will feel compelled to chase performance in order to boost returns before the calendar turns.

Since 1991, there have been nine years in which fewer than 40% of large-cap fund managers outperformed the S&P 500 by the end of the third quarter, according to Goldman. In those instances, the S&P 500 then rallied by 2% more in those fourth quarters than other years when more funds were outperforming the market.

That’s part of the reason Goldman predicts the S&P 500 will keep rallying through the fourth quarter and finish the year at about 2050.

“In addition to the supply/demand dynamics from underperforming funds, the environment of continuing above-trend US GDP growth, strong corporate earnings, and still-accommodative Fed policy should support a continuing ‘grind higher’ in U.S. equities,” Mr. Kostin said.