Passive investing has been in favor for the past several years as low volatility and generally solid returns have made these low-cost options popular. But with a change in market conditions as interest rates rise, will stock-picking make a comeback, or will investors stick with the passive indexes?
The popularity of exchange-traded funds, vehicles that generally follow an index and use a rules-based methodology, have challenged active management on a few fronts.
First, many ETFs charge very low fees. Basic funds that follow the S&P 500 stock index, such as SPDR S&P 500 Trust (ticker: SPY), the biggest ETF, charges 9 basis points. Even a low-cost mutual fund like Vanguard Total Stock Market Index ( VTSMX), still charges 14 basis points for retail buyers. Active mutual funds that pick stocks charge much more. According to the Investment Company Institute, in 2017, the average expense ratio of actively managed equity mutual funds was 78 basis points.
That higher cost doesn’t always mean better performance. Morningstar, the Chicago-based research firm, releases a semi-annual report called the Morningstar Active/Passive Barometer that measures the performance of active versus passively managed funds within various categories.
In its most recent report, Morningstar says just 36 percent of active stock-pickers outperformed their average passive peer over the 12 months through June 2018. In 2017, 43 percent of active managers achieved this feat.
Sticking with passive indexing when the S&P 500 returns 19 percent a year, as it did in 2017, looks like the right call for investors, and it can be harder for an active manager to surpass that benchmark when index returns are high. But the environment for stocks is changing as the Federal Reserve normalizes monetary policy. If the stock market turns choppy with few gains, will investors return to active management to try and improve their portfolios?
It’s never easy. Ted Theodore, chief investment officer at TrimTabs Asset Management in New York, says a choppy market doesn’t necessarily make stock picking any easier, so a change in the market environment won’t necessarily draw investors back to active management.
He says changes in the industry have hurt stock pickers. Active managers are less “active” — part of that is there are fewer active funds around as investors have moved money to passive funds because of lower fees, and he says there’s a lot more “closet” indexing going on by active managers than before.
“If you could just stick to your guns and just find stocks (to) pick, we’ve found it it’s been pretty good for us…. even before the market got choppy or worrying about the next cycle,” he says. “But I’m not arguing that the active is going to make a comeback. The challenge is to try to find some kind of approach that adds some value.”
Although the S&P 500 index is up about 11 percent this year, it’s not been a straight line up, so theoretically active managers should be able to add value by finding buying opportunities when markets retreat, says Todd Rosenbluth, senior director of ETF and mutual fund research for CFRA in New York.
The fees will always be a challenge for active managers, he says, but investors are also starting to look for funds that are different than the benchmark, looking for that opportunity to outperform. But if the benchmark is dominated by a few stocks driving performance, such as a some technology names are doing now, investors who are underweight those stocks or have a portfolio different from the benchmark could underperform, Rosenbluth says.
Indexing becoming more active. Kip Meadows, chief executive officer of Nottingham, a fund administrator and white-label ETF issuer based in Rocky Mount, North Carolina, says some newer ETFs are becoming a little more active and less plain-vanilla index-based. However, many of the active ETFs aren’t truly active in a traditional stock-picking sense, in that they follow a rules-based index that might change its holdings every quarter.
Some of these funds fall under the “smart beta” or “factor investing” category, funds that follow long-standing academic research such as value stocks outperform growth stocks over the long run, or small-cap stocks eventually do better than large-cap stocks. Thematic ETFs, which group together stocks on a theme, like robotics, are also proliferating. However, these types of funds remain a small part of the ETF landscape.
Meadows says in the past few years he had expected greater interest in actively managed ETFs, but admits it hasn’t taken off like he thought it might. Still, he says, if market returns become meager, that could spur interest in active ETFs.
“When things are going sideways, people do start to look at fundamentals, which is where the human brain does have a place in analyzing the data,” he says.
Using ETFs in an active way. Rosenbluth says financial advisors are starting to use indexed ETFs in an active way, rather than relying on picking stocks themselves or using a mutual fund.
“They’re not fully replacing, but they’re increasingly replacing individual stocks and can be traded or invested in quite similarly to individual stocks,” he says. “I think that’s highly appropriate.”
Mike Piershale, president of the Piershale Financial Group in Barrington, Illinois, says this is how he uses ETFs, and he almost exclusively uses these investment vehicles now. Piershale says they research market trends and then pick the ETFs that express those views, revisiting the decisions quarterly.
“We use passive index ETFs; we just love them and our clients love them,” he says.
Theodore says his clients use his funds as an alternative to their core stock holdings to give these financial advisors a little more of a boost to the overall portfolio.
Rosenbluth says active management does have a place, even as passive investing is firmly rooted for most investors.
“Even though a lot of money has gone into the low-cost, well-diversified, market-cap weighted product, many investors still wants to do better than that and just want something that is different,” he says.
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