Wall Street has a dirty little secret: most actively managed funds underperform the market. As a result, more and more money is going into so-called passive index funds, which track an index and do not try to time or beat the market. These funds received over $166 billion from investors in 2014, while active funds actually lost over $98 billion.
More and more, investors are looking to profit from the rising tide of a growing economy, dismissing the talent or skill of picking stocks as a relic of the past. However, some analysts believe that this move towards passive index investing may not outperform as robustly as it has in recent years, thanks to one major change to the U.S. economy.
What stockpickers do
Active investing has one primary goal: to choose those investments that will provide a stronger return than the market as a whole, while avoiding those investments that will provide a lower or negative return. The methods that active investors use to make these decisions are complicated and various; many disagree with each other on which strategies work and which don’t, so generalizations are hard.
That said, many will develop a model or method of screening stocks based on certain market characteristics, like revenue growth, dividend payment history, market share, and so on. These characteristics will then be used to decide how much of a portfolio should be placed in one stock—or whether that stock should be bought entirely. In theory, this helps investors avoid bad investments while weighing more heavily on the good ones.
Why it didn’t work
There are two big problems with stock picking: market conditions and the Federal Reserve.
Market conditions change. A company that has made a huge profit in the past may fail to do so in the future if a market suddenly changes for one reason or another. The best stockpickers cannot predict everything that will happen, so changes to a market due to disruptive technology or changing trends can catch investors off guard. A great example is Radio Shack (RSH), the once ubiquitous staple of malls across the country. The company saw its stock price rise twentyfold in two decades thanks to consistent growth and a name brand that was recognizable and reliable. Then new technologies that required less gadgets and less gadget repair meant Radio Shack’s reason for existing vanished. Now the company is expected to file for bankruptcy.
Good stock pickers can anticipate these changes to a market, and adjust their portfolios accordingly. But we all make mistakes, and so those errors from money managers will drag the portfolio’s performance down. This problem is worsened by the dragging effect of fees, which only drags a portfolio performance down over time.
Secondly, there is the effect of the Federal Reserve on the stock market. Several analysts and pundits have noticed the same thing: the Federal Reserve’s monetary policy known as Quantitative Easing causes stock prices to rise. This trend is indiscriminate, causing all equities to rise with an expanding monetary base. When this happens, it’s very hard to outperform the market, because the market is going up so much and so fast, regardless of the fundamentals of the companies inside that market. This has been a big hurdle for fund managers over the past five years.
Crucially, this monetary policy has changed in the United States, which has already caused some new trends in the stock market. After earnings season began, many companies have seen their stock prices impacted much more by fundamentals now that the Federal Reserve has stopped its QE program. As a result of this dynamic, some are arguing that stock pickers may be back—in 2015, they say, a lack of QE and high valuations in the market mean the stock picker will likely outperform the market.