Mutual funds post worst year ever by Colin Barr @FortuneMagazine January 4, 2011, 4:56 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons The embattled mutual fund industry didn’t do itself any favors in 2010. Just one in five large-cap fund managers outperformed the Russell 1000 index last year, according to Bank of America Merrill Lynch. That is the worst performance on record, says quantitative strategist Savita Subramanian. They get slaughtered That’s quite a showing, one richly deserving of the 30-plus straight weeks of stock fund outflows we saw at one point last year. No wonder people are throwing whatever money they have at ETFs. But wait, there’s more: As poorly as actively managed funds performed throughout the year, they managed to finish on an even worse note, just as the market was rallying. Entering December, a quarter of funds were running ahead of their benchmark indexes, Subramanian writes Tuesday in a note to clients. But another dismal month, with fewer than half of managers beating their bogies, took that number down to a dismal 20% by year-end. She blames the junk rally that lifted off in the holiday season. Given that the December rally was led by low priced, small cap, less liquid companies that are inherently difficult for large cap managers to meaningfully overweight, performance was hard to come by – last month, the lowest priced companies which constitute about 10% of the benchmark, contributed almost 20% of its returns. But then, performance has been hard to come by for some time for the actively managed funds. That’s why, for instance, Vanguard this year passed Fidelity to become the biggest mutual fund company, and why exchange-traded funds recently passed the $1 trillion in assets mark. Yet hope rings eternal, and there’s always good reason to suspect the herd is headed in the wrong direction. BofA notes that underperforming managers didn’t lag all that far behind their benchmarks, and says the coming year could yet turn last year’s trends on their head. Active managers, and indeed fundamentally driven stock selection strategies, have suffered in 2010 as the riskiest stocks have contributed the largest proportion of returns. We believe that stock pickers could make a comeback in 2011. Clustered performance has begun to abate as clarity has improved on the macro front, and performance spreads appear to be bottoming, suggesting a better environment for stock pickers. And historically, fundamental strategies and actively managed stock funds have had strong outperformance following years of high correlations and low performance spreads like 2010. So there’s your quantitative outlook for 2011: It’s a stock picker’s market. The stock pickers certainly hope so.