Why it’s so difficult to beat the S&P 500

, Why it’s so difficult to beat the S&P 500 It is not a secret. As the S&P 500 and other US stock market indexes have seen big gains in the last five years, active managers have struggled to outperform.

Bloomberg reported (using Morningstar data) earlier this year that just 20 percent of actively managed funds investing in U.S. stocks beat their main benchmarks in 2014. This is right in line with the average 21 percent that topped the indexes in the last five years. Unsurprisingly, money has moved dramatically into low-cost funds, mainly ETFs, that track indexes.

So why do professional managers have such a hard time beating the S&P 500?

One of the main reasons is that when the S&P 500 removes a company and adds another, the new firm tends to be an outperformer:

The median stock removed from the S&P 500 has had negative earnings growth in the preceding three- and five-year periods. The earnings growth of the companies added to the index is not only much superior to the companies removed, but also much higher than those companies already in the index.

This causes a substantial, structural upward bias to the earnings growth of the S&P 500 index. In fact, there is a 1.2% growth rate difference between the new companies added to the S&P 500 and the index without them. This difference has remained for the last 8 years, according to research by Morgan Stanley.

It seems investment managers may employ a good investment strategy simply by buying the new companies that are included in the S&P 500 each year.