Friday, March 8, 2013

It Just Goes to Show You, It's Always Something: Active Stock Management

It Just Goes to Show You, It's Always Something: Active Stock Management

The Wall Street Journal’s Alexandra Skaggs wrote the kind of story that appears every twelve to eighteen months.  This one was titled “Amid a Record Rally, Stock-Picker Funds Aim for a Turn in the Spotlight[1].”  The article suggests that company-specific factors, rather than broad market factors, are now driving stock prices.  As a result, money managers who conduct fundamental research should outshine passive index investing.  As evidence, the article cites the fact that large cap managers have beaten the S&P500 by 0.1% in the first two months of the year.  This is hardly a compelling thesis.


Shut It Down? (1999)

Active money managers are always saying that we are entering a stock pickers market.  I am sure you’ve heard refrains such as, “stock selection is going to be more important than ever.”  Or, “picking the right companies is going to drive performance.”  Every so often, active money managers enjoy a brief period where they beat their respective benchmarks.  However, by the time investors realize that active managers have accomplished this feat, their performance erodes again.


As Roseanne Roseannadanna, the character created by the late Gilda Radner, complained, “it’s always something.”  As stocks tumbled in 2008-2009, active managers crowed that this was an opportunity for stock pickers to pluck the best companies from the worst companies at bargain prices.  When their strategies didn’t work, they grumbled that the correlation between individual stocks was too high.  In other words, individual securities price movements were overly synchronized. 


Then in 2010-2011 when the indexes triumphed yet again, the culprit became insufficient volatility.  Stock prices weren’t jumping around enough to give active managers the opportunity to enter or exit securities at attractive prices.  When volatility spikes up again, and managers underperform, they’ll lament that they were “whip-sawed” by the market.


Today’s claim that fundamental factors are driving stock prices sounds like a good argument for active portfolio managers.  The logic goes like this.  If the sales, profits, and cash flows of individual companies are relatively more important than macro trends, then the stock selectors should beat passive indexes.  However, there’s a huge flaw in the argument.  To succeed, active managers have to be able to systematically predict these fundamental trends and hope that they are not already reflected in stock prices.  By the time they account for trading costs, fees, and mistakes, active managers will be doing their best impression of Roseanne Roseannadanna, “You see it’s always something, if it ain’t one thing, it’s another.”



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