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John Kinsellagh
John Kinsellagh
Articles (77) 

Will Active Fund Managers Perform Better in the New Market Environment?

For the past decade, everyone was making money in the market. Recent market volatility signals the good times are over. Can stock pickers now beat their benchmarks?

May 18, 2018 | About:

The at-times contentious debate among investment professionals is well-known and has been around since time immemorial: Would a typical investor garner a better return by using the dart method or by following the advice of a fund manager or “expert?"

This long-running discussion was revisited and achieved new vigor with the advent of State Street’s SPDR — the first ETF offered to the investing public. Since that game-changing event, two rival camps have competed for investors funds. Which is better, trying to beat the market or simply tagging along?

Over the past decade, low cost index and “robo” advisors have taken a bite out of traditional fund managers business with an unprecedented infusion of cash going into these low-cost investment alternatives.

During last decade’s bull market run, when every ETF fund seemed to be rising in tandem, traditional mutual funds and investment advisors had a hard sell to prospective customers. Why pay a management fee of 1% or greater in addition to costs, when an investor could put money into an index fund for an annual management fee in a range of 0.25% to 0.75%? Better still, the ETF fund matched and, in many cases, surpassed the return of the actively managed stock funds.

But now that the heady days of quantitative easing and a zero-interest rate environment are over, will passive methodologies perform as well as actively managed funds? Will astute stock pickers be able to beat the averages and find underpriced securities?

Active fund managers argue that historically unprecedented low rates meant that a lot of highly-leverage companies could remain in business and there was little risk differential between large and small caps. Everything was going up and everybody, no matter the investment vehicle chosen, everyone was making money.

For the past decade, the pricing of asset classes was badly skewed. The bond/equity relationship was inverted, which helped fuel the stock market’s upward trajectory. Active proponents are correct when they say that, as evidenced by recent market volatility, the good times are over.

The S&P 500 index is the most actively traded security in the world. This is not surprising since a substantial portion of passive indexes seek to mimic this ubiquitous benchmark with the result that the massive influx of funds tends to bid up the price of large-cap stocks while some smaller stocks remain undervalued. This presents opportunities for active fund managers.

Data from Morningstar for the first quarter of this year would appear to bolster proponents of the active investing approach. Although only half of actively managed stock funds beat their benchmarks for the past five years, their record is improving. Data from Morningstar reveals that 53% of active funds beat their benchmarks in the first four months of this year, an increase from 49% last year and 29% in 2016.

The performance of actively managed stock funds has been mixed and by no means has it supported an argument that investors are better off handing their money to a stock picker to invest. However impressive the relative return of some selective funds may be, the overall picture is still murky.

The same Morningstar data shows that last year, 63% of active small-cap growth funds and 54% of active small-cap value funds beat their benchmarks, up from 29% and 18%, respectively, in 2016. Although this is an improvement, still, barely more than half of the active funds are outperforming the indexes.

Although the exodus of funds to passive vehicles continues, active managers can take solace in the fact that at least the rate of outflows has declined. Morningstar data indicates that the dollar exodus for the 12-month period ending in February is down 15% from the same period in the prior year.

Although these figures for active managers are encouraging, they are by no means definitive proof that active stock funds can and will outperform passive investing going forward. Since the investment climate has changed dramatically, it is too early to tell whether stock pickers, in the intermediate or long-term, will be able to consistently outperform index or robo investing.

In light of these uncertainties, perhaps the most prudent posture for active managers to adopt would be one of cautious optimism, pending sufficient data to support their thesis

Advocates of both active and passive management philosophies are both right and both wrong. Fund managers who subscribe to the efficient market hypothesis are unlikely to be dissuaded about the virtues of passive indexing investing.

These managers suggest the influence of technology and the rapid dissemination of information means stocks do not remain undervalued for long. Mitch Tuchman, managing director at Rebalance IRA in Palo Alto, California, believes that active management will become extinct. “Today when you find something mispriced, others find out the same things very quickly,” he says. “The time frames are shortened,” he noted.

However, technology in and of itself will not entirely eliminate market inefficiencies; other factors affecting the market are more determinative, such as overall investor sentiment, presence of the herd mentality — at times prevalent among fund managers — and the sentiment and psychology of individual investors. Factors that are unforeseeable today may impact the future investment climate in ways unimagined.

As Benjamin Grahman noted frequently, intelligent investors should not expect the past at all times to be a reliable predictor of the future direction of the market.

The applicability of this time-tested adage is one of the reasons the active vs. passive argument will likely continue for the foreseeable future.

About the author:

John Kinsellagh
John Kinsellagh is a freelance writer, former financial advisor and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts’ Society course on "Investment Analysis and Portfolio Management."
He has served as an arbitrator for FINRA for over twenty-five years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community and personal finance.
He is the author of "Election 2016", available on Amazon.

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