U.S. equity mutual funds do not mirror the overall domestic stock market. That isn't necessarily bad, it's just the way it is.

Consider the makeup of the equity market. There were 7,608 individual U.S. stocks with a one-year return in 2009. Of that total, approximately 250 were large-cap stocks (according to the Morningstar Principia database). Thus, just over 3% of stocks were large-cap companies. The vast majority of U.S. stocks are mid-caps and small caps. In fact, as of year-end 2009, small-cap U.S. stocks represented over 89% of the domestic equity universe, while mid-cap stocks accounted for about 8%.

Now, consider the makeup of U.S. equity mutual funds. Of the 2,601 domestic equity funds (those with at least 85% of their portfolios in U.S. stocks) that had a full one-year return in 2009, 51% were large-cap funds. Mid-cap funds represented 26%, with 23% of all equity funds categorized as small-cap funds.

Simply put, in the U.S. market, most stocks are small caps, and most mutual funds are large caps. Thus, the behavior of domestic equity mutual funds can be quite different from the average performance of the overall U.S. stock market. This was true again in 2009, when only 0.4% of all equity funds suffered a loss, while nearly 40% of all stocks had a negative return.

One way to determine how stock performance compares with equity fund performance in any given year is to look at how several different cap-related indexes performed that year. If the discrepancy among the indexes is small, then fund and equity performance will be similar. If the discrepancy is large, performance could be quite different.

TEN-YEAR COMPARISON

About half of all U.S. stocks have a negative return in the average year, although the actual percentage ranges from 15% in 2003 to 89% in 2008 (see "Man Down," on page 99). Thus, an investor who randomly picks a portfolio of stocks each year has about a 50% chance of losing money. Those odds aren't very encouraging.

Now, let's consider the performance of equity funds. On an annual basis, the performance of equity funds is quite different from the performance of the stock market as a whole. Simply put, it's feast or famine for funds (see "Platoon Down," also on page 99).

In 2000, over half of all equity funds had a loss. In 2001, it was even worse, with over 77% experiencing a one-year loss, despite the fact that less than half of all stocks had a negative return that year. In 2002, the wheels fell completely off as over 97% of all funds lost money, and fewer than 63% of all stocks had a negative return.

Then, from 2003 through 2006, nearly all equity funds had positive annual returns for four consecutive years. (The population for each year was selected from Morningstar Principia at the end of each year to eliminate the impact of multiyear survivorship bias.)

For example, in 2005, when over half of all stocks had a negative return, only 6.4% of all equity funds lost money. Likewise in 2006, only 2.1% of equity funds had a negative return despite nearly 40% of all stocks suffering a one-year loss.

Fund performance started to deteriorate in 2007, when almost 27% of all equity funds had a loss. Still, that was far better than the overall stock market, where nearly 64% of companies lost money.

Then came 2008, when the performance of stocks and equity funds rocketed in the same direction-down. Nearly all of the 2,871 equity funds (99.8% to be exact) had a one-year loss. The average equity fund return in 2008 was -38.3% (which combines large cap, mid-cap and small cap). Interestingly, though, "only" 89% of all stocks had a negative return in 2008. The average return of all 8,020 stocks in 2008 was -39.6%.

In calendar year 2009, the equity fund universe was nearly flawless, with only 0.4% of all 2,601 funds suffering a loss. As mentioned earlier, the news was not so good in the equity world, where nearly 40% of all stocks had a negative return.

THE CAP EFFECT

On average, about 35% of equity funds have a negative return in any given year. However, that average is not stable. In reality, equity funds tend to have herdlike performance-uniformly good or uniformly bad (as shown in "Platoon Down"). Bad years were 2000, 2001, 2002 and 2008. Good years were 2003-2006, and 2009, with 2007 being a mixed bag,

The reason for this herdlike performance ties back to the makeup of the equity market and mutual funds. Most stocks are small stocks, but most equity funds tend to invest in large stocks.

Not surprisingly, the annual performance of the U.S. stock market looks very different based on which index is used (see "Three Snapshots," on page 101). The three indexes in this comparison are the S&P 500, the Russell 2000 and the Wilshire 5000 Equal Weighted. The S&P 500 is a measure of large-company performance and is market-cap weighted. Larger companies exert more influence over the performance of the S&P 500. The Russell 2000 represents the smallest 2,000 companies from the Russell 3000 (an index that seeks to represent the entire equity market). The Wilshire 5000 Equal Weighted (EW) seeks to capture the performance of the entire equity market without the influence of market-cap weighting.