Despite the popularity of passive strategies, shrewd stock pickers may soon have their day, Jeff Benjamin reports.
After more than four years of riding the stock market wave with passive index-based strategies, some financial advisers and market watchers are starting to consider the potential for active management to navigate the next market cycle.
“What we've seen over the past few years is highly leveraged, low-quality companies outperforming low-leverage, high-quality companies, but that's not going to go on forever,” said Kevin Malone, president of Greenrock Research, a firm that helps financial advisers build portfolios for their clients.
He isn't forecasting an immediate end to the environment that has favored index-based investing since the stock market bottom in March 2009. But the tea leaves that Mr. Malone is reading that suggest that active management's day is coming.
“Coming off market bottoms, investors want to invest so they buy indexes to jump on the bandwagon,” he said. “But we're at a point now where the expectations are for slow growth for the next few years, and that's why we believe high-quality companies will be the types of investments that investors will want to gravitate toward.”
The recent stock market volatility tied to concerns over the Fed's monetary policy should stand out as a clear indication that the table is being set for shrewd stock pickers.
“If you knew the market was going to go up 100%, you wouldn't need to screw with active management, because in a bull market less is more. But the truth is, an active strategy gives you more opportunities for downside value,” said Paul Schatz, president of Heritage Capital LLC.
Like most advisers, he doesn't think that the active-versus-passive debate is an all-or-nothing proposition.
Mr. Schatz does, however, think that too many investors make the transition at the wrong time.
“Right now, you're five years into a bull market that could go on for two or three more years, but given its duration, you should probably have a combination of active and passive strategies,” he said. “To me, investors always think about this at the wrong time, like at the end of 2008 and most of 2009 when everyone was looking for active strategies.”
The S&P 500 has gained more than 140% since March 2009, a fact that hasn't been lost on investors.
Over the trailing five-year period, actively managed equity mutual funds tracked by Morningstar Inc. experienced more than $443 billion in total net outflows, while index-based mutual funds saw total net inflows of more than $245 billion.
Performancewise, equity index funds have outperformed active funds year-to-date as well as in the trailing one-, three-, and five-year periods.
“Right now, the head winds are certainly against active management because there isn't a big distinction being made among the investor class between good companies and bad companies,” said Chris Bouffard, chief investment officer of The Mutual Fund Store LLC.
“But we're starting to see some correlations go down, and when that happens, there is less focus on the macro risk-on and risk-off trades,” he said. “When you have fewer of those all-or-nothing days, that's when active managers start to have some wind at their backs.”
Mr. Bouffard expects to see more support for active management as the Fed starts reducing its pace of quantitative easing, which is expected to start next month.
“In the environment when investors are just saying 'get me in or get me out,' you don't really have ideal capital allocations because the money is just going out there and lifting all the boats,” he said. “But when the Fed starts pulling back, you would expect it to lead to an environment that's more conducive to active management.”
Just as there are purists who think that passive management is always the best course, there are those able to make a case for active management all the time.
“We are believers in the long-term potential of active management to add value, but it is the case that you've had some head winds to active management in recent years,” said Alice Lowenstein, director of portfolio strategies at Litman Gregory Asset Management.
“We've been seeing markets reacting to macro factors and policy issues, and that can make it more difficult to invest based on fundamental factors,” she said. “We believe in active management, but only if you're going to do the research necessary to find that small percentage of managers that can outperform, and be willing to take the risks of investing with an actual active manager and not a closet index.”
The distinction between a true active manager and a closet index fund is most easily identified in performance comparisons, which sometimes means not keeping pace with an index.
“There's an ongoing debate of active versus passive, and which side you're on usually depends on whether you're invested in an active fund or work for an active manager,” said Todd Rosenbluth, fund analyst with S&P Capital IQ.
“If you're going to go active, try and pick the lowest-cost funds that have outperformed the benchmarks,” he said. “Most people end up investing in more expensive funds that are average or underperforming.”
