The boom in low-cost, passively managed index funds has been one of the biggest finance stories of the 21st century thus far. And it’s been supported by the fact that over the long run, most active fund managers underperform their benchmarks.
But 2017 has been an unusual year. According to data from Bank of America Merrill Lynch, most active fund managers (55%) were beating their benchmarks year-to-date (YTD) through October. That number slipped to 49% in November, but continues to be noteworthy.
“The silver lining: 49% is still the highest hit rate (at this time of the year) since at least 2009,” Bank of America’s Savita Subramanian said in a December 4 research note.
The debate about active versus passive rages on. This conversation has occurred against a backdrop where index exchange-traded funds (ETFs) have become massive as the stock market (^GSPC) has rallied for over eight years. Stock-picking, active fund managers have seen their picks get lost in a rising market that has lifted all boats. It’s a tide that has seen billions flow out of actively-managed funds and into passively-managed funds.
But things might be starting to turn for the active managers.
Low correlations make for a stock picker’s market
Part of the story of this year’s performance is that correlations, or the degree to which stocks move together in the same direction, have come down and an opportunity for stock picking has presented itself.
“[Correlations] between stocks have actually come down quite a bit this year. That allows for more opportunity for stockpicking and often times it corresponds to a less macro-driven market and [to a] more micro-driven market,” Bank of America senior equity strategist Dan Suzuki said. “That tends to be when you see lower correlations, which a lot of active managers tend to be fundamental stock pickers and so that environment, in theory, should help those types of people.”
It’s one thing to have the opportunity to pick stocks in a low correlation market, but it’s another thing to pick the right stocks.
“This year, the stocks that have outperformed tend to be the stocks that active managers have positioned in,” Suzuki said, adding, “This year, the biggest driver of market performance has been tech, and tech is by far the biggest overweight for fund managers.”
One of the overarching themes of the market in 2017 is how performance has been largely driven by the tech stocks. Goldman Sachs recently looked at 804 hedge funds with $2.1 trillion in assets. The bank’s analysis found that the top five most popular stock positions include Facebook (FB), Amazon (AMZN), Alibaba (BABA), Alphabet (GOOGL), and Microsoft (MSFT).
Don’t bet on consistent outperformance
In general, the active managers are making a comeback in the sense that they are on track for their strongest year as far as Bank of America’s data goes back.
“Now are they going to put together consistent outperformance? I think that’s less likely,” Suzuki added.
That said, he noted that active fund managers’ performance tends to do better late in cycles and also during bear markets.
“So, as we get later in the cycle that should in the near term help fund manager performance. And, also, if we do start going into bear markets that could help their performance. In the very near term, there are factors that would suggest fund performance would be better than what we are used to.”
Don’t ignore fees
Another factor that could help performance is fee pressure. As fees come down, it’s less of a drag on performance. And the only thing investors care about is the performance on an after-fee basis.
One of the arguments that has been driving this ongoing shift from active to passive management is the fees. For the most part, active fund managers’ performance doesn’t justify their fees. Even famed investor Warren Buffett, known as the greatest stock picker of our time, has argued that investors should put their money in low-cost index funds.
“The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds,” Buffett wrote in his annual letter.
John Lynch, the chief strategist at retail investment advisory LPL Financial, argues that the dynamics that have supported passive strategies have begun to fade.
“There’s almost been a mania relative to passive and I think it’s important that if you no longer have the world’s largest central bank artificially suppressing the short end of the curve, there will be ramifications,” Lynch said. “You may well see passive perform well in Europe and Japan, for example, but I think you will see active outperform passive in the U.S. with the Fed going in a different direction.”
The long-term outlook looks good for stock pickers
According to Lynch, monetary policy has been “a great tailwind” for passive investing. With the Federal Reserve hiking rates and reducing the balance sheet, it presents an opportunity for investors to determine which companies are strong or weak.
“The bottom line is that the re-emergence of a more ‘classic’ business cycle, where investors can determine winners and losers based on fundamentals, should support active management’s recent positive momentum in 2018,” Lynch wrote in a recent report.
During Bank of America’s year-ahead press briefing on Tuesday, Savita Subramanian, the head of U.S. equity strategy, also made a case for fundamental stockpicking.
“I think the easy money to be made today is stock selection based on fundamentals with a long time horizon. I’m not talking 2018. I’m talking about the next ten years. I think that’s the most contrary theme, the theme that nobody talks about anymore that’s likely to be the most alpha generative for our clients,” Subramanian said.
Economic theory would suggest that returns are greatest where capital is scarce, Suzuki added. Over the last few years, there’s been a tremendous amount of money flowing to shorter-term, more quant-oriented strategies. Billions have flowed into the hedge fund industry, which is typically focused on shorter-term strategies.
“As all this money is competing on different parts of the short-end of investment horizons — one of the greatest opportunities are areas where there’s more scarce capital is investors that are investing in fundamental stories with long-time horizons,” Suzuki said, adding, “If you are Graham and Dodd-based, essentially you’re basing your investments simply based on valuation and fair value, then those returns work best over long-time horizons.”
Unfortunately, very few people in the industry truly have long-term investment horizons.
“That’s one of the greatest opportunities,” he added.
Of course, all of this comes down to manager selection. And on aggregate, active managers haven’t been able to outperform the market. For most investors, though, having the ability to pick the right manager is elusive.
“So much time is spent picking the right manager, like stock-picking in a sense,” Suzuki said. “Picking your manager based on previous performance doesn’t translate into future performance.”
Julia La Roche is a finance reporter at Yahoo Finance. Follow her on Twitter.