Before you give your investment manager an ear full for trailing the S&P 500 last year, check out this article from Barron’s. Lots of useful insights that can help you stay the course and avoid the emotionally charged decisions that often sabotage long-term portfolio performance.
It is no secret that index funds have gained in popularity in recent years. The proliferation of ETFs has been a big boon for the index fund community. According to the Investment Company Institute, in the first 11 months of 2014, investors pulled $96 billion from active U.S. equity funds and purchased over $100 billion of U.S. index funds.
While the index fund providers would have you believe that investors have suddenly found index investing religion, performance is probably a much bigger driver. Index funds have been a tough bogey to beat in a bull market that has pushed stock valuations far into the stratosphere. Last year only 20% of active managers beat their benchmarks.
Why are investors trialing their benchmarks? Here’s what Barron’s has to say on the topic, plus much more. Your can read the full article here (subscription required). Emphasis is mine.
Before you write off active management just yet, consider the backdrop of the past, oh, three decades. A closer look at the economic environment — and how it’s changing — offers some perspective on the challenges and, yes, advantages of active management. Perhaps the news of its death has been greatly exaggerated.
From 1962 to 1981, when the 10-year Treasury yield more than tripled, from 3.85% to 15.8%, the median cumulative return for large-company mutual funds (including those that have since closed) was more than 62 percentage points better than the S&P 500, or an average of 3.2 percentage points per year. In other words, $10,000 invested in an active fund that earned the median return in that stretch would have $13,000 more than the same investment in an S&P 500 index fund. That lead reached 70 percentage points in 1983, then steadily eroded as interest rates headed down.
Investors expect better-than-index returns but aren’t willing to suffer bigger-than-index losses, notes Rob Isbitts, founder and chief investment strategist at Sungarden Investment Research in Weston, Fla. “Most people should be more concerned with how to get a realistic target return,” he maintains.
As more money moves into the indexes, it could create more opportunity for stockpickers. “It becomes a self-fulfilling prophecy,” says Arik Ahitov, co-manager of $1.2 billion FPA Capital(FPPTX). Ahitov says more than a quarter of the companies in his bogey, the Russell 2500, have net negative income. “You have all of these unprofitable companies going up, and nobody seems to care. An index fund doesn’t distinguish between what is and isn’t profitable. Everything moves together.” His fund has averaged 14.4% annual gains since 1984, versus 11.9% for its benchmark. But, like many deep-value funds with large cash positions — recently 28% of assets — it has lagged behind lately, last year by nearly six percentage points.
Of course, to get active management, you need funds that are truly active. That’s where “active share” — the percent of holdings that differ from a benchmark — comes in. According to economist Martijn Cremers’ research, funds with at least 90% active share beat their benchmarks by 0.81 percentage points, after fees, from 1990 to 2013. Those with active share below 60% consistently underperformed by 1.01 percentage points annually, after fees. And, he notes, the proliferation of passive products has encouraged active managers to distinguish themselves by becoming more active.
For truly active managers, down years are inevitable. “When you concentrate a portfolio with your best ideas, you aren’t always going to be in favor,” says James Hamel, who runs the $1.2 billion Artisan Global Opportunities (ARTRX), which has 46 holdings and more than half its assets in its top 20 stocks. “But that’s the only way to create alpha.”
Jeremy Jones, CFA
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