It's hard to resist the siren call of stock-picking when markets turn volatile: There are rallies to exploit and dips to avoid. How should we respond to this temptation?
The numbers certainly work against us when you compare the performance of actively managed mutual funds against a passive exchange-traded fund that tracks a major index – such as the S&P 500, which many passive investors rely upon for their U.S. equity exposure.
In 2015, as with today, global stock markets also turned a bit wonky. They were roiled by plunging crude oil prices, a rising U.S. dollar, volatile bonds and the usual concerns about stock valuations and the longevity of the bull market.
Whatever the cause, the S&P 500 fell more than 9 per cent between July and September and ended the year relatively unchanged. ETFs that track the index looked like dead money that year, while stock pickers had free rein to take advantage of the volatility.
But according to S&P Global, this freedom didn't amount to anything. Its S&P Indices Versus Active report – a regular summary of active mutual-fund performance, which takes into account asset size and survival rates among funds – shows that just one-third of money managers beat the index in 2015; two-thirds lagged, suggesting that the blind meanderings of a passive ETF can outperform brilliant stock pickers at a time when these stock pickers would appear to have all the advantages.
Bigger rumblings in the stock market have also revealed an inability among professional stock pickers, as a group, to outperform.
S&P looked at two downturns: The devastating market implosion of 2008, when the S&P 500 fell 37 per cent; and the 2000-2002 bear market, when the S&P 500 fell 49 per cent after the dot-com bubble burst.
If stock pickers had avoided absurdly pricey technology stocks during the bubble or sidestepped the financial crisis with little or no exposure to U.S. financial giants, then they should have beaten the index handily.
They didn't. S&P reports slightly fewer than half of all large-cap funds outperformed the index during either downturn. S&P analysts concluded: "The belief that bear markets favour active management is a myth."
Why? One reason is fees: Active managers charge more than passive ETFs, because of salaries and trading expenses. So even if the raw performance of stock pickers is index-beating, fees tend to weigh them down.
Another reason is that major indexes tend to be efficient, leaving stock pickers with few mispriced stocks and market anomalies to exploit, even during downturns.
Increasingly, individual investors are discovering that ETFs have their advantages, which is why mutual funds are struggling to attract new assets while ETF assets have been growing in popularity and are now spawning robo-advisers.
But here's a confession: Even though I accept that I'm not going to beat the market with my few piffling stock trades outside of core ETF holdings, I can't help but try. And the stock-market turbulence of the past week has convinced me the downturn will deliver wonderful bargains. Am I delusional?
I hope not, and for support I cling to a line from Burton Malkiel's classic ode to index investing, A Random Walk Down Wall Street: "For all its hazards, picking individual stocks is a fascinating game."
Thank you, Mr. Malkiel. Should I be denied the fun that comes from wagering the negative sentiment surrounding General Electric Co. is a bit overblown right now? Or that U.S.-dollar assets can get a tailwind should the greenback recover?
A good part of my modest stock portfolio also consists of companies that have big and rising dividends: Enbridge Inc., Altria Group Inc., Hydro One Ltd., Power Corp. of Canada and Brookfield Infrastructure Partners LP. If they outperform their underlying indexes, great. But really, I'm more interested in the cash they spin off.
And finally, stock-picking – and more generally, market timing – provides a nice psychological cushion when the markets hit a rough patch. Being fully invested in index-tracking funds just hurts when markets are tumbling, tempting us to abandon strategies at the worst moments.
But armed with cash, and the nerve to use it, we can see a see a downturn for what it is: an opportunity.