It's a Weird Market. Time To Go Active. -- Barrons.com
DOW JONES & COMPANY, INC. 6:01 PM ET 5/22/2020
If stockpickers have a chance of salvaging their reputations, this is it. A violent selloff and equally rapid ascent in the stock market has caused mispricings and created massive disparities among sectors and stocks, giving actively managed mutual funds an opportunity to beat the index's return, after lagging behind badly throughout the long bull market.
Some financial advisors, including longtime skeptics of active management, are moving money into these strategies. They believe that the market is acting irrationally enough to give good managers the chance of beating their benchmarks, and that a longtime trend toward lower fees has lowered the hurdle to out performance.
"It makes sense to be surgical now more than ever," says Ron Carson, CEO and founder of Carson Group, an Omaha advisory, which last quarter added an active strategy to U.S. stock allocations and is in the process of switching all of its developed international allocation to active funds from about a 50-50 split.
"When the economy is humming along, the rising tide raises all boats. But we're going to see a major contraction this quarter and massive volatility," Carson says. "To find companies gaining market share even if their prices are going down takes a manager digging into a company's debt structure, free cash flow, fundamentals. Talking to suppliers, looking upstream and downstream. Hours of homework."
The move by Carson and other advisors is a fresh vote of confidence for actively managed mutual funds, most of which trailed passive strategies throughout the long bull market. In August, the amount invested in passive funds hit $ 4.3 trillion, exceeding assets under active management among individual investors for the first time and cementing the dominance of indexing. For some advisors, however, pruning passive and adding active exposure began before the February stock market pullback, as they prepared for what they thought would be an end to the 11-year bull market and lower returns in 2020.
"The markets were overbought, and there's no cerebral cortex to a passive approach," says Andrew Rosen, an advisor at Diversified in Wilmington, Del. "We use passive to grab big swaths of the market, but added active managers to tilt portfolios and use rationale to increase and decrease positions."
Rosen says that he continued to add active managers as the market pulled back sharply in response to Covid-19. "We wanted to both protect on the downside and position for a recovery," says Rosen, who switched 10% of his passive holdings to active, including all international stock investments and some U.S. stock and fixed-income holdings. He particularly likes T. Rowe Price Blue Chip Growth , Federated MDT Small Cap Growth (QASGX), Invesco Oppenheimer Developing Markets (ODMAX), and Baird Aggregate Bond (BAGIX).
For years, active managers have been making the case that they would shine in a market downturn, using human intelligence and financial analysis to assess stocks that were unfairly punished. The logic is sound, but the execution is tough.
Among active U.S. stock funds, winning managers are almost always in the minority. Consider that there was no rolling five-year period over the 22 years from 1997 to 2018 in which more than 50% of managers beat their Morningstar category, according to Morningstar research. For the rolling periods ending in each of the five years from 2014 to 2018, less than 20% of managers had success.
The data cast a better light on U.S. stock fund managers during periods of unrest in the markets. The high-water mark for actively managed U.S. stock funds was after the technology bubble burst in 2000, when more than 70% of active fund strategies beat passive counterparts.
"It was a turkey shoot in the sense you had this extreme divergence between growth stocks and value, large and small, domestic and foreign," says Jeffrey Ptak, global director of manager research for Morningstar. "When you have those kinds of spreads, it's a boon for active investors. Success rates went through the roof."
In the recent V-shape downdraft and bounce in stock prices through April, 48% of U.S. active stock managers outperformed their category indexes. During the downswing from Feb. 19 to the trough on March 23, 53% outperformed, according to Morningstar.
Looking ahead, advisors say they expect the climate to continue to be tough for stockpickers in the large-cap space.
"We had a major market break, but the leadership in large-cap stocks hasn't changed -- the Big Five ( Amazon.com(AMZN) [ AMZN], Alphabet's Google(GOOG) [GOOGL], Apple(AAPL) [AAPL], Facebook(FB) [FB], and Microsoft(MSFT) [MSFT]) account for over 20% of the S&P 500 index," says John Apruzzese, chief investment officer at Evercore Wealth Management, who is in the process of shifting all international exposure to active strategies.
"People would think it would be active managers' heyday, but it's very difficult to outperform the S&P 500 when the megastocks are still leading."
Those who are adding active management in U.S. large-cap allocations are nibbling rather than making big changes, often choosing concentrated portfolios of 30 to 40 stocks so the manager has agility and flexibility -- theoretically, at least -- to dodge risks and snap up opportunities.
Judith McGee, chairwoman and CEO of McGee Wealth Management in Portland, Ore., has long favored active managers but has held about 15% in passive options, primarily in U.S. stocks. She recently reduced that to 5%, adding a high- conviction U.S. value manager, American Funds American Mutual (AMRFX) and an active ETF with a focus on technology called ARK Innovation (ARKK).
"We're not just looking at offense; this is for defense, too," McGee says. Both active funds have a strong record: Each trounced benchmarks and at least 90% of peers in the past one, three, and five years.
The shift to active strategies has been more aggressive in small-cap U.S. stocks, international stocks, and fixed income, where actively managed funds have a higher success rate and many of the indexes are structurally unappealing to advisors. "We are moving from a mix of active and passive in international developed stocks to all active," says Evercore's Apruzzese. "The international indexes [are] full of things we don't want."
For example, banks have been weakened by negative interest rates and dividend cuts, Apruzzese says. Auto manufacturers are grappling with weak sales and the high cost of switching to electric vehicles, and oil companies are facing major restructuring needs and dividend cuts, he adds.
Last year, 46% of U.S. small-blend managers beat their indexes compared with 35% of U.S. large-blend funds. The benchmark-beating rate among international stockpickers was significantly higher: 58% of foreign large-blend and 68% of diversified emerging markets managers.
Obviously, switching to active management is successful only if the advisor picks the right mangers. Academic studies have shown that it's difficult to predict which managers will outperform, but one good indicator is fees. Lower- fee funds produce the highest returns across every asset class. Other factors that advisors prioritize are low turnover (to keep taxes down), easy access to managers, and a high active share. Low active share means that a fund looks just like the benchmark -- owning the same stocks in roughly the same proportion, making it hard to justify higher fees.
Lori Van Dusen, founder and CEO of LVW Advisors in Pittsford, N.Y., acknowledges that even if you invest with the best manager, moving away from index investing comes with a risk. "If you get a big broad-market bounce, you might miss it," she says, but adds that the dislocations in some major global markets have been extreme and are best analyzed by seasoned stockpickers. She has shifted assets to active managers in U.S. small-caps, emerging markets, and fixed income.
That's completely different than her approach through the 2008 market rout. Coming out of 2008, stocks were cheap and bond interest-rate spreads blew out so dramatically that investors couldn't go wrong in index funds, Van Dusen says. "Now, with a rolling gradual opening of the economy, you have to have a lot more skill in small-caps and debt to understand the difference between solvency and liquidity issues," she says. "A lot of companies today are financially fragile, and some are not. There's opportunity for people who can understand which are which."
Active fixed-income funds haven't had a great track record lately in beating their benchmarks. Among corporate bond funds, just 26% did last year and 48% in 2018. But with interest rates so low, index funds in fixed income don't seem poised for a big bump this year, so many advisors are selecting unconstrained fixed-income managers, who can pick and choose where to invest across fixed-income asset classes and internationally.
"With the 30-year Treasury paying around 1.5%, it's almost impossible to make money passively in bonds right now," says Steve Podnos, a principal at Wealth Care in Cocoa Beach, Fla., who recently raised his active allocation in fixed income from 70% to 90%. "And what happens when interest rates start to go up? Passive medium- to long-term investments will get hammered. Being active allows us to invest both domestically and internationally in a number of different areas of fixed income." He favors Pimco Income (PONAX), DFA Five Year Global Fixed Income Portfolio (DFGBX), and Fidelity Total Bond (FTBFX).
Some advisors who traditionally avoided active managers because of high fees say that a steady, yearslong decline in fees has been a game changer. "We've always been extremely fee conscious; fees have compressed enough that active fees are justified," says Leon LaBrecque, chief growth officer at Sequoia Financial Group in Troy, Mich. He has fully embraced active management in fixed income and is considering adding active managers to his mostly passive stock portfolio.
U.S. stock funds charge an average 0.7% compared with passive funds' 0.1%. Taxable-bond fund average expense ratios are 0.53% for active and 0.12% for passive.
A broad shift from passive to active isn't glaring in fund-flow data, but some trends are notable. The cheapest active funds steadily saw inflows throughout the bull market, according to Morningstar. The firm also notes that in January and February of this year, a net $24 billion went into active funds. Sure, that's significantly less than the $ 78 billion that went into index funds, but it ended a 10-month trend of steady net outflows.
Investors reversed course in March and yanked massive assets out of both active and passive funds. Jitters continued in April, but a more granular look shows that investors pulled far less out of actively managed U.S. stock funds than passive, and that actively managed stock sector funds had net inflows.
The emphasis on active strategies goes beyond mutual funds and ETFs. Some advisors say the pullback in asset prices has prompted them to allocate more to private investments and other nontraditional asset classes.
"We're looking at some private-equity and venture strategies that we passed on in the fall because of pricing, but now pricing has come down, " says Deb Wetherby, founder and CEO of Wetherby Asset Management in San Francisco. Real estate and private lending are among the areas of interest, she says.
Some advisors say that while they haven't expanded active allocations, they've been elbow-deep in assessing their current managers.
"Moving forward, active managers will be able to add the most value in areas such as technology, health care, parts of finance, and consumer," says Kent Insley, managing director at Tiedemann Wealth." He particularly likes Akre Focus (AKREX), which has more than 75% in cyclical stocks such as financial services and real estate, and has beaten its benchmark and at least 90% of its peers in the trailing three-, five-, and 10-year periods through May 12.
As markets continue to roil, many advisors say they've been spending days conferencing from their home offices with colleagues to discuss strategies for the next few quarters. Gary Hager, president and founder of Integrated Wealth Management in Red Bank, N.J., is a big believer in passive investing, but is prepared to move about 10% of his portfolios to active management if the market delivers another pullback. "Because of the speed and violence of the market's move down and up in the first quarter, there was never an opportunity to implement our plan," he says. Given continued economic duress, he adds, "I suspect there will be."
