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With just a handful of trading days left in 2023, the story of the year is pretty well baked.

The "Magnificent Seven" stocks fueled a stock rally driven by AI hype while the Federal Reserve delivered investors a "soft landing" this year and signaled lower interest rates in the year ahead.

Take these storylines together and it's little wonder the S&P 500 gained over 22% while the Nasdaq climbed over 42%.

This ascent has pushed Wall Street strategists to continue raising expectations for the year ahead and seen stocks enter much-feared "overbought" territory.

But these indicators, which are often taken as a contrarian sign for investors of weakness ahead, may not be enough to overcome another problem hanging over the heads of many portfolio managers across Wall Street this holiday season — underperformance.

New data from Tom Lee at Fundstrat published Monday showed that most professional investors are still underwater when compared to their benchmark.

The firm's data showed that through the end of last week some 65% of large-cap fund managers were trailing their benchmark by an average of 6.5%. This data captured 577 funds with nearly $3 trillion under management benchmarked to either the S&P 500, the Russell 1000, or the Growth or Value variations of these indexes.

Lee notes that this 35% of large-cap fund managers beating their benchmark lags the historical average of closer to 45%. Data from S&P Dow Jones Indices cited by TKer earlier this year showed 2023's underperformance got worse as the year went along, with 40% of managers trailing the market at the halfway mark.

All of which, in plain English, means that while the stock market as measured by the S&P 500 and Nasdaq has had a great year, many investors have struggled to keep pace, potentially putting pressure on these investors for the balance of this year and into 2024.

In Lee's view, an elevated number of investors lagging their benchmark could encourage these folks to chase this year's winning trades — notably the Magnificent Seven stocks and, more recently, financials, among others — into the final weeks of the year.

On the one hand, this is a short-term look at how markets might behave in the next few weeks. (Lee's overall recommendation for clients is to remain a dip buyer into year-end.)

But we think Lee's work illuminates the importance of relative performance for most investors and how this creates the kind of pressure that pushes someone to chase markets in an effort to turn a poor year into a middling one.

The investors Fundstrat's work captures by and large aren't working with retail clients, but institutions like pensions, endowments, or "fund of funds" managers. And these folks don't pay high fees to get an investment that matches the market or runs a portfolio that looks like, say, the S&P 500.

Rather, they pay for a strategy that attempts to beat this benchmark — or the other aforementioned variants — and also does it while providing a different risk profile.

Lee notes that the "concentrated gains of FAANG contributed to the performance challenges for large-cap managers." As Yahoo Finance's Josh Schafer noted earlier this year, the Magnificent Seven stocks including Apple (AAPL), Alphabet (GOOGL, GOOG), Microsoft (MSFT), Amazon (AMZN), Meta (META), Tesla (TSLA), and Nvidia (NVDA) have risen more than 70% this year as a group and comprise roughly 27% of the index's market cap.

Were a 50-stock portfolio, for example, to exhibit a market cap imbalance similar to the S&P 500 you'd have one stock accounting for roughly a quarter of the portfolio's overall value. And the kind of active manager that Fundstrat's data tracks does not court institutional investors by putting a quarter of their portfolio into a single idea.

Which leaves 2023 as a perfect storm for active managers.

Because not only has the market rallied against broad expectations for a slide in stocks and a downturn in the economy, but the rally has been led in large part by a handful of stocks overrepresented in the index and underrepresented in most investor portfolios.

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