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Active Managers Trail Index Funds, Again.

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Active Managers Trail Index Funds, Again.

Stock Pickers Have Tough Time in 2014
Republished from: “Wall Street Journal”
June 29, 2014 3:24 p.m. ET

This year was supposed to be a good one for stock pickers. Things aren’t working out as planned.

So far in 2014, more actively managed mutual funds are trailing market benchmarks than in any full year since 2011, according to data from Morningstar.

In some cases, the gap is stark. More than 74% of actively managed funds that invest in shares of big U.S. companies are lagging behind the S&P 500 index, up from 50% last year. It is the second-worst performance on record going back to 2004, according to the fund researcher. The story is similar across many categories of funds investing in small- and midsize stocks.

This development has frustrated many stock pickers who were hopeful at the start of 2014, following years in which many of them were unable to post returns in excess of market benchmarks.

Unlike funds tethered to an index, stock pickers on actively managed funds aim to beat the broader market by selecting shares they think will outperform. In many instances, fund managers found themselves on the wrong side of this year’s unexpected market moves, from the selloff in growth shares to the rally in utilities. They also have been hampered by the lack of big swings in stocks, making it harder to single out market-beating shares.

John Bichelmeyer’s $396 million Buffalo Emerging Opportunities fund has fallen 7.2% this year, trailing its benchmark, the Russell 2000 Growth index, which is up 1.6%. “It’s never fun to get your butt kicked,” said Mr. Bichelmeyer.

The fund, which buys shares of small companies, has beaten the Russell index in four out of the past five calendar years, including 2013, when it delivered a 61.7% return, nearly double the S&P 500’s rise including dividends.

Mr. Bichelmeyer attributes the underperformance this year to a spring tumble in shares of rapidly growing companies and slower-than-expected U.S. economic expansion—factors that hampered other fund managers as well. Mr. Bichelmeyer’s fund has bounced back over the past month as many of those shares recovered, but it hasn’t been enough to make back the lost ground.

The challenges haven’t been confined to mutual funds. Hedge funds that take long and short positions in stocks have returned just 1% this year, well behind the S&P 500’s 6.1% gain, according to Goldman Sachs. GS -0.04%

Stock picking is always a risky game, and actively managed funds often lag behind indexes. The proliferation of index funds has made it easier for investors to ride moves in major benchmarks at little cost, and some market observers see actively managed funds as not worth the extra expense.

Still, active managers say 2014 has been particularly frustrating. As the year began, many signs were pointing to a banner performance for those focused on buying and selling individual stocks.

Individual stocks were showing the first signs of becoming unshackled from each other after moving essentially in lock step since the financial crisis. That gave some investors hope that stocks would start trading based on company-specific factors such as earnings or growth or even their attractiveness as a takeover target. That would give stock pickers an edge.

Investors also expected more back-and-forth trading in 2014 after stocks’ broad push higher during 2013’s second half, which would give pickers some opportunity to outpace their indexes.

One big reason a stock pickers’ market hasn’t panned out is that the rally has been a slow, steady grind higher, with few big swings. The result has been that returns from individual stocks have fallen largely within a small range, a phenomenon known as low dispersion.

“The missing link is dispersion,” said Craig Lazzara, senior director of index investment strategy at S&P Dow Jones Indices. “In an environment of low dispersion, the amount by which a winner can win is less.”

The difference between the worst and best 10% of stocks in the S&P 500 shrank to 14.4 percentage points in May, its lowest ever in data going back to 1990, according to research by investment firm Matarin Capital Management.

“Had that market climate materialized, it is likely that the dispersion of returns would have been wider,” said Jon Hale, director of North American manager research at Morningstar. “Instead, interest rates have fallen, volatility has been low and stocks have moved upward across nearly all sectors.”

One prediction did come true: Shares are now increasingly moving on their own merits rather than in response to larger macroeconomic events.

Correlations between individual shares in the S&P 500, measured over a 60-day period, have fallen to 0.31 this year, according to research firm Axioma. This month, they fell to a three-year low of 0.27. A correlation of 1 means all stocks trade in the same direction. In late 2011, as the euro-zone debt crisis intensified and the U.S. credit rating was downgraded, the measure rose above 0.7.

Still, that hasn’t been enough for active managers. Other, more-fundamental missteps have fed into their market-trailing returns: The economy hasn’t accelerated as quickly as many had anticipated, and investors overall have gravitated toward larger stocks, rather than the small stocks that many active pickers tend to buy.

Lew Piantedosi, a portfolio manager on the $150 million Eaton Vance Large-Cap Growth fund, came into the year with a bet on consumer discretionary stocks as part of a broader view of an improving U.S. economy. But the economy contracted 2.9% in the first quarter and the S&P 500 Consumer Discretionary sector index is down 0.4% in 2014.

Mr. Piantedosi is sticking by his bet. Most economists blamed the first-quarter drop on the harsh winter and expect growth to rebound.

Meanwhile, Mr. Piantedosi’s fund is up 7.1%, lagging behind the S&P 500 by 0.1 percentage point including dividends.

“People have had a hard time outperforming,” he said. “Unless you’re really nimble and tactical…it’s been difficult.”

Fund managers say that a rebound in smaller stocks would help active-management returns. Others are looking to the resurgence in mergers and acquisitions this year, which allows portfolio managers to make bets on potential buyout targets.

“This enormous amount of M&A activity has really helped stock pickers get back into the game,” said John Rogers, lead manager of the $2.1 billion Ariel Fund.

He said some of his picks, including merger adviser Lazard Ltd. LAZ +0.81% , have benefited from the pickup. “The big pops can be extraordinarily helpful.”

Write to Dan Strumpf at [email protected]


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