The art of professional stock picking is dying… or so we’re led to believe.
Active management involves selecting securities to own based on research and analysis. The idea is to pick attractive stocks and outperform the market.
In theory, picking the best stocks is a great idea. In practice, however, the performance of active managers has been woeful.
Research conducted by Standard & Poor’s has shown that the majority of active managers across all domestic equity categories failed to deliver returns higher than their respective benchmarks.
The numbers are so bad that they’re hard to believe…
Over the past three years, 77.5% of all domestic equity funds were outperformed by their benchmarks.
Because of this underperformance, investors are voting against active management with their feet. Domestic, actively managed stock funds have experienced a $46.3-billion outflow this year.
The California Public Employees’ Retirement System (CalPERS), the nation’s largest pension fund, is even considering cutting back its allocation to active equity strategies.
On the other hand, passively managed funds, which simply mirror the composition of a market index, have experienced a $42.3-billion inflow year to date.
Passive investing, or index investing, is being increasingly viewed as an optimal investing approach.
The thinking being, if you simply hold each stock in proportion to the size of its market cap (stock price times shares outstanding), then turnover, fees, and taxes are minimized.
Vanguard, which now manages over $2 trillion, has thrived due to the popularity of indexing.
But there’s a significant flaw with index investing…
As a stock becomes more popular, its price rises, thereby increasing the market cap. So market cap weighting actually punishes you over time by holding more expensive stocks in higher proportions. This is exactly the opposite of what you would want.
Well, the fund industry has produced an interesting solution to this deficiency of cap weighting. It’s called “smart beta.”
Active by Another Name
Also known as fundamental indexing, “smart beta” was pioneered by Research Affiliates.
It differs from the cap-weighted approach that’s been so successful at Vanguard, in that smart beta breaks the link between price and portfolio weights. Instead, stocks are weighted based on other factors, such as sales, cash flow, book value, or dividends.
The result is a portfolio that’s more representative of the underlying economy, more tilted towards value, and less dependent on the popularity of individual stocks.
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I would argue that smart beta is really active management in disguise, because it uses a systematic process to determine appropriate weights for each stock.
This method implies that the market has mispriced securities and that the manager can select more appropriate metrics (known as factors) to determine portfolio weights. The rebalancing process becomes a source of alpha, or outperformance.
Regardless of how smart beta is categorized, the results have been favorable…
Research Affiliates has partnered with PowerShares to develop a line of fundamentally indexed ETFs. Since its inception in December 2005, the FTSE RAFI U.S. 1000 ETF (PRF) has produced an annualized total return of 8.6%. The Russell 1000 Index only returned 7.6% over the same timeframe. This outperformance, net of fees, is likely making many traditional active managers very envious.
WisdomTree has also had success with its smart beta ETFs. For example, the WisdomTree MidCap Earnings Fund (EZM) has produced an annualized return of 9.6% since its inception in February 2007. This bests the 8.1% of the S&P MidCap 400 Index.
So, smart beta strategies are working over the long term, whereas conventional active management is not.
I think the big difference lies in the process. Many stock pickers rely too heavily on gut feel or intuition. Their methods are more qualitative and less quantitative. This means that they will constantly have to keep their emotions in check and stay disciplined – a very difficult task without a methodical framework or rules-based strategy.
Bottom line: Everyone who is serious about beating the indexes needs to develop a systematic investing process. Smart beta is one such approach.
The death of stock picking has been greatly exaggerated. Active management is simply undergoing a transformation, and those with the best processes are winning.
Alan Gula, CFA