FEDERATED HERMES, INC. That didn't work out: As the benchmark Standard & Poor's 500 Index gained 29.6 percent in its best year since 1997, mutual funds run by stockpickers slightly lagged cheaper index funds.
2014 was also supposed to be the year of the stockpicker as the S&P 500 rose 11.4 percent, until it wasn't. Last year, active managers underperformed comparable index funds by the worst margin in more than a decade.
This year, pundits ranging from money managers to publications like Barron's are saying this is finally going to be the year that strategic stock pickers will best the indexers. After six straight years of gains, they say the stock market is once again showing flashes of the stomach-churning drops that allow active managers to exert judgment and pick up shares at lower prices.
"There's a level of volatility in this market which makes it very ripe for stockpicking skills to be rewarded," said Phil Orlando, a portfolio manager and chief equity strategist at Federated Investors (>> Federated Investors Inc).
Well, maybe. The last year in which stockpickers beat passive funds by a wide margin was 2007, which was also the last year the Colorado Rockies played in baseball's World Series or A.C. Milan won the European Cup in soccer. To be sure, past performance doesn't necessarily indicate future results, as fund managers like to say.
As active managers underperform, they are increasingly fighting an uphill battle for assets. Investors have shunned active management since the current bull market began in 2009, sending $444.6 billion (294 billion pounds) to index funds and exchange traded funds while pulling $421.2 billion out of those run by stockpickers, according to Lipper data.
Vanguard Group, which launched the first index fund in 1975, has become the largest U.S. mutual fund company by assets largely by catering to investors who shun the idea that the average stockpicker can beat the market after fees, an idea popularized by firm founder Jack Bogle.
"Regardless of market conditions, for every winning trade there's someone who had to sell it to them, making the market a zero sum game," said Jim Rowley, a senior investment analyst at Vanguard.
DISPERSION AND DOLLARS
The stock market is becoming more volatile. In January, the volatility of the benchmark S&P 500 index was nearly 10 percent higher than its 50-year average, said Howard Silverblatt, senior index analyst at S&P Dow Jones indices.
Over the last 90 years, periods of low dispersion - a measure of the range of returns for stocks in a benchmark - have been difficult for stockpickers, with October of last year hitting the third-lowest dispersion on record, said Thomas Lee, head of research at New York-based Fundstrat. Yet periods of extremely low dispersion tend to give way to those where dispersion is above average, making it easier for stockpickers to be rewarded for their choices, he said.
Fund managers say that they are already reaping the benefits of more volatile markets.
"The hardest environment is when stocks move in unison and stockpickers don't have an opportunity to do their thing," said Bob Doll, a portfolio manager at Nuveen. This year, his Large Cap Core
"Now, companies are being valued on their fundamentals and you are rewarded for making the right call," Doll said.
Orlando, from Federated Investors, said that the stronger dollar should also help stockpickers who shift into more U.S. focussed companies this year. The average company in the S&P 500 gets about half of its revenue from overseas. Those with smaller market caps tend to earn most of their revenue in the U.S. and are less affected by the dollar's jump.
Overall, the higher dollar could shave up to $12 billion off of U.S. companies' fourth-quarter 2014 revenue alone, according to FireApps, a data analytics company in Phoenix, Arizona. [L1N0V61CU]
"Moving down the market cap will mean less of a currency impact, while the biggest companies in the index are getting hurt," Orlando said.
REASONS TO BE SKEPTICAL
Yet investors have reasons to be skeptical that certain market environments favour stockpickers, analysts say.
With so many actively managed mutual funds - there are 4,635 large-cap funds alone tracked by Morningstar (>> Morningstar, Inc.) - there is little reason to think that all of them will react to the same environment in the same way.
"I don't know that any one variable helps the light bulb go off across an industry with so many different strategies involved," said Jeff Tjornehoj, head of Lipper America research.
Moreover, higher levels of volatility don't always help stockpickers, according to Thomson Reuters data. As measured by the VIX, the so-called fear index which measures the amount of risk about the size of changes in a security's value, volatility spiked to above 40 in August of 2011 and remained above its historical average of 20 for the remainder of the year. Yet active managers underperformed that year, losing an average of 2.1 percent compared with an average loss of 1 percent among passive funds.
In 2007, the last year in which stockpickers beat passive funds by a wide margin, volatility never jumped above 30, according to Thomson Reuters data. The VIX is currently at 18, below its long-term average.
Only about 40 percent of stockpickers beat the benchmark in any given year, said Todd Rosenbluth, director of fund research at S&P Capital IQ. Should stockpickers once again underperform this year on average, fund companies may be under increasing pressure to lower the expense ratios of actively-managed funds in order to regain the market share that they have lost to index funds and ETFs.
The average actively-managed equity fund charges $1.37 per $100 invested, according to the Investment Company Institute, while comparable index funds often charge $0.25 per $100 or less. As a result, stockpicking fund managers have to outperform the index by a greater margin just to make up for their higher fees.
"There's only so many years that active management can underperform before investors start to say that enough is enough," Rosenbluth said.
(Reporting by David Randall; editing by Linda Stern and John Pickering)
By David Randall
