“Comeback is a good word, man,” noted the actor Mickey Rourke, after portraying a washed-up wrestler led to a career renaissance. Could 2017 be the year when stockpickers can say the same thing?
The post-financial crisis environment has been unkind to active investing, especially in equities, with most portfolio managers unable to beat their benchmarks even before costs. That has accelerated the seismic investor shift towards cheap, passive investment vehicles like exchange traded funds.
The improved performance of US equity fund managers in the second half of 2016 only put some lipstick on what was, on the whole, a pig of a year. Bank of America’s Savita Subramanian estimates that just 19 per cent beat their index, even worse than the 41 per cent beat rate of 2015. Moreover, outflows reached a new post-crisis high, while inflows into exchange traded funds averaged $1bn a day globally — or over $12,300 every second of every day, even with the extra day in the leap year.
But there is finally some light at the end of the tunnel. Hopes are mounting that 2017 will restore the lustre of traditional active management.
The expectation is that more volatility and greater dispersion between individual stocks and markets will allow skilled managers to shine more readily. Indeed, almost two-thirds of clients surveyed by Tabb Group last year reckon that active management will enjoy a renaissance in the new market environment under Donald Trump, which appears more conducive to stockpickers.
In a report entitled “Making Active Management Great Again,” RBC strategist Jonathan Golub argues that common active manager “tilts” — like leaning towards smaller companies, favouring cheaper shares and eschewing steady, slow-growing but dividend-generous companies that have been on a tear in recent years — will make a comeback this year.
Lower fees will also help. Competition from cheap passive vehicles have forced most asset managers to slash their own prices, making it easier for funds to beat their benchmarks after fees.
The average expense ratios of US equity funds have fallen from about 99 cents for every $100 invested in 2000 to 68 cents in 2015, and for the average bond fund from 76 cents to cents, according to the Investment Company Institute. And most fund managers do still manage to outperform the market before fees.
Yet sceptics will point out that the return of active management has been heralded many times before. Volatility that is supposed to sort the wheat from the chaff has instead had a tendency to serially wrongfoot even the investing industry’s biggest names.
Weighted by assets, the average hedge fund gained under 3 per cent last year, according to HFRI, and Bank of America’s strategists have found no evidence to suggest that rising interest rates or higher volatility helps mutual funds perform better.
Even after the late-year rally in many mutual fund darlings, simply buying the 10 companies least favoured by mutual funds at the start of 2016 — as measured by their holdings — would have made an investor 13.4 per cent last year, while the 10 most popular picks only gained 5.9 per cent. This is at least the third year in a row where it would have paid off to do the opposite of what stockpickers did, notes Ms Subramanian.
Moreover, it is far from certain that the new environment will be that much more conducive to stockpicking. Many fund managers hope that the rise of passive investing vehicles like exchange traded funds will lead to less efficient markets with more distortions they can take advantage of, but Credit Suisse’s Michael Mauboussin is sceptical.
In a recent note he argued that active fund managers who have been forced out of the market were probably the weaker ones, which should in fact make it even harder to beat the market, comparing it to a competitive game of poker.
“The investors leaving active managers are likely less informed than those who remain. This is equivalent to the weak players leaving the poker table,” he wrote. “Since the winners need losers, this can make the market even more efficient, and hence less attractive, for those who remain.”
The new year should be a time for hope, but film buffs will recall that Mr Rourke’s career stalled again soon after his role in Darren Aronofsky’s The Wrestler. Sometimes a comeback turns out to be merely a blip in an otherwise steady downwards trajectory.
