Evidently, it’s tough to be a stock-picking mutual fund manager today.
The Wall Street Journal reports¹ that investors have shunned actively managed funds, preferring the lower expense alternative of passive or unmanaged funds that replicate such indices as the S&P 500.
Independent research firm, Morningstar, confirms The Wall Street Journal’s assertion by reporting that, last year, investors pulled $13 billion in assets from active managers and invested $244 billion into passive indices. The reason for the reversal in fund flows? Outperformance. According to Morningstar, 74% of active managers underperformed their respective index in 2014.
This investment trend raises several questions: What is passive investing? Have all indices handily outperformed active managers over the last few years? Is a passive strategy the best long term approach for most investors?
Passive Investing Defined
Passive investing involves investing in an unmanaged grouping of stocks or bonds. The most popular passive investment is the Standard & Poors 500 Index (S&P 500). This index is made up of the 500 largest U.S. stocks by market capitalization.
Creation of an index is a relatively simple process: take the price of a stock included in the index and multiply by the number of shares available for public trading. For example; today the largest stock in the S&P 500 is Apple (APPL), which makes up approximately 4% of the index. Towards the bottom of the list you will find Fossil Group (FOSL), which makes up less than .20% of the index.
Other unmanaged indices include the 30 stock Dow Jones Industrial Index, The S&P Mid Cap 400 Index and the Russell 2000 Index, to a name a few. Among the numerous indices, on the bond side, the most notable is the Barclays Capital Aggregate Bond Index, which is made up of government, corporate, and securitized bonds. There are also indices for commodities, real estate, and international equity markets.
Outperformance of Large Stock Indices
Why has the S&P 500 been so hard to outperform over the last several years? There are a number of reasons touted for this outperformance; chiefly among them is the efficiency of markets. Large stocks that make up indices like the S&P 500 are covered by hundreds of analysts from investment firms all over the world. Once information about a stock becomes public, the data is quickly disseminated through this network of analysts, informing the market and affecting the price accordingly. Given this efficiency, stock pickers have a difficult time taking advantage of information that others may not have.
Another reason for outperformance is expenses. Since there is little expense involved in buying a basket of companies, expenses are low for indices, usually around .13%, compared with the average actively managed stock funds, which Morningstar reports to be .85%.²
But possibly the biggest factor for recent outperformance is the Federal Reserve, “People may not fully grasp the true impact of Quantitative Easing,” says Matt Krauss, managing director of RGT. “The U.S. has embarked on a program that has substantially increased the amount of liquidity in the investment world. As a result, stocks, along with real estate, bonds, and private equity have all enjoyed a broad rally. All ships have risen in the sea of liquidity and investors are more focused on overall stock exposure versus fundamentals in play at specific companies.” Krauss continues “In some instances, stocks were not necessarily stellar investments, but increased in price because their membership in a certain index caused them to receive massive inflows of investor dollars, thus driving up the price of the stock”. Conversely, stock pickers have struggled because investors perceived that earnings, valuations, and other metrics were less important than huge inflows of money.
Cycles and Risk
Both active and passive management enjoy periods of popularity and scorn. Unfortunately, these cycles can be easily lost on investors. Passive investments have outperformed active management for much of the last decade. Will this continue? Time will tell, but now that the Federal Reserve has ended Quantitative Easing and large stock indices are nearing historically high valuation levels, this period of outperformance could be coming to an end.
Recall the technology bubble of 1990’s. The technology sector experienced meteoric rises in stock prices, with many companies grossly overvalued despite weak fundamentals. Indices like the S&P 500 were consistently outperforming active managers whom could not stomach the valuations and dubious earnings of the technology sector. This came to an abrupt end when the bubble burst in the early 2000’s and stock prices began to fall rapidly.
By March of 2000, the S&P 500 had a 34% weighting of technology stocks, leading to a 48% crash in the index’ value over the next two years. The technology laden NASDAQ suffered greater losses and did not regain its previous high for 14 years. When considering passive investing, investors must be mindful that indices are unmanaged groups of stocks; their prices can rise without a solid basis to sustain such growth. If an index becomes horribly expensive, generally, a correction soon ensues.
On the other hand, stock pickers value stocks based on a combination of fundamental, technical, and qualitative analysis. They choose investments by looking for stocks to which the market has assigned an incorrect value. Active managers who underweighted technology in the early 2000s, held up much better in the downturn following the technology bubble. With the market’s renewed focus on earnings and valuations, active managers performed well against passive indices through the financial crisis.
Active Management Excels
Not only do active managers perform well during periods when market performance is uneven, they also perform well in more inefficient areas of the market such as smaller stocks, international stocks, and the bond market. While hundreds of analysts may be covering large, blue-chip stocks, many smaller companies may be covered by only a few. S&P Capital IQ reports that companies with over $10 billion in market capitalization average 26 analysts covering their business.³ Companies with $500 million in market capitalization average only 2 analysts with 1,100 of these smaller firms having no coverage at all. These inefficient markets allow active managers to outperform, based on investment skill. Morningstar indicates that 54% of active managers outperformed the Russell 2000 between January 1996 and the end of 2014.⁴
A passive strategy can make sense for an investor who has limited time to conduct due diligence on their investment portfolio. “However, we still believe in active management,” says Chuck Thoele, managing director and chief investment officer of RGT. “Ultimately we ask ourselves what is best for our clients. If the answer was to invest passively, we would. However, there are a number of managers in the market place today that, over time, have markedly outperformed their respective index. When we interview managers, we ask ourselves, ‘why have they outperformed? Is their process repeatable, and is their business healthy?’” This strategy has served us well for over 25 years.
Matt Krauss and Mark McClanahan are managing directors at RGT Wealth Advisors.
¹ Grind, Kisten. (January 4, 2015). Vanguard Sets Record Funds Inflow: Investors Gave Stock Pickers a Vote of No Confidence in 2014. The Wall Street Journal. Retrieved from http://www.wsj.com/articles/vanguard-sets-record-funds-inflow-1420430643.
² Pleven, Liam. (March 20, 2015). How to Pick a Stock Picker. The Wall Street Journal. Retrieved from http://www.wsj.com/articles/howtopickastockpicker1426868681.
³ S&P Capital IQ. (December 31, 2014). Retrieved from: http://www.spcapitaliq.com/.
⁴ Morningstar Direct. [Chart illustrating average percent of mutual funds beating the benchmark. Based on annual excess returns since 1996.]