Bob Farrell was a revered former strategist at Merrill lynch and his Ten Rules of Investing still influence modern day professional investors. One of these rules, "When all the experts agree — something else is going to happen" now applies to the debate active versus passive investing strategies.
In an October 3 research report, Merrill Lynch's current chief quantitative strategist Savita Subramanian recently noted that 54 per cent of active U.S. fund managers were beating their benchmarks so far in 2017, "the highest hit rate at this time of the year in our data history going back to 2009."
How can this be true? Didn't we agree that all active fund managers are flailing, overpaid morons?
The truth remains that passive, broad index-based investing is the best option for the majority of investors over the long term – all of the credible research shows that. But, it is also important to note that the relative performance of active and passive investing strategies is cyclical, and we might be entering a market environment where active managers have a better chance to beat the index.
The past few years have seen the U.S. market driven in large part by the FANG stocks – Facebook Inc., Amazon.com , Netflix Inc and Google parent company Alphabet Inc. In these circumstances, it is almost impossible for portfolio managers to beat the benchmark.
In markets driven by a small number of companies their stocks inevitably become expensive, as Amazon.com's price to earnings ratio of 244 times underscores. In the interests of managing portfolio risk, very few fund managers are willing to hold marketweight positions in stocks when they are that overvalued. So they hold an underweight (or no) position in Amazon that almost guarantees the fund underperforms the benchmark for as long as the trend lasts.
Portfolio managers typically outperform when market leadership is broad – when a large number of companies contribute roughly equally to index returns. With this market backdrop, a skilled manager can beat the benchmark by buying the most attractively valued (cheapest) of the market leaders.
I would suggest that investors add to holdings in actively managed funds here, but practical concerns preclude it. With thousands of fund options available, it's simply too hard to separate quality portfolio managers from flash in the pans.
But I also wouldn't be surprised if Mr. Farrell's rule applies, and after 'passive is better than active' became the consensus view, portfolio managers enjoy an extended, if temporary, period of proving this wrong.
-- Scott Barlow, Globe and Mail market strategist
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Compiled by Darcy Keith