Why it's stockpickers' time to beat the market

That report, known as the SPIVA Scorecard, which has been published for more than 20 years, seeks to distil the passive versus active debate by simply comparing the performance of managed funds against their local equity benchmarks. Over shorter time horizons, the contest is closely fought; for example, around two-fifths of large-cap US funds managed to beat the S&P 500 in the year to 30 June, even after fees.

But the further you pan out, the worse things look for the active crowd. Around the world, in market after market, those who know (or profess to know) most about equities fail to match the returns of simple, low-cost tracker products. And tough comparisons over one year end up multiplied over longer time horizons, which is why only around one in 10 funds have come in ahead of the market in the past decade.

If this assessment looks especially brutal, it may be because the SPIVA ranking offers a truer picture than the active industry sometimes cops to. By looking at every fund that qualified at the start of a scorecard’s period, including those that then merged or were liquidated, the methodology removes the so-called survivorship bias, giving investors a real account of their chances of beating the market.

Nor is this a new phenomenon. In 2008, confident the odds were on his side, Warren Buffett offered $1mn (£790,000) to any Wall Streeter who could select a portfolio of hedge funds that would outperform the S&P 500 index over the next 10 years. The one investor to accept the wager threw in the towel before the decade was up.

Suspicions around active’s value for money were shared by Buffett’s long-time investing partner, Charlie Munger, who died last week aged 99 after a career as one of the greatest stockpickers of all time. Earlier this year, he criticised most active managers’ failures to acknowledge their inability to match index returns over the long haul, and their “moral depravity” for charging high fees despite the fact.

“Maybe 5 per cent consistently beat the averages; everybody else is living in a state of extreme denial,” Munger told February’s annual meeting of the publisher Daily Journal, where he was latterly a director.

Read our obituary of Charlie Munger – the man behind Buffett

Was that ‘then’?

And yet (in the drama of markets, there is always an ‘and yet’) is there a chance that passive’s apparent victory was a product of a very specific set of circumstances?

To be clear, it will always be hard to beat the market both mathematically and psychologically. For a start, ‘the market’ is both inescapable, and the raw material with which active investors must work. And so long as equity indices remain the benchmarks of choice, active stockpickers will anchor their performance, expectations and self-perception to the market average. Clouding this, our natures bias us towards loss avoidance, fads and other tripwires.

Still, if this isn’t a moment for active investing to assert itself, it’s hard to know what might be.

Active managers have always made the case – part sales pitch, part bid for survival – for their relevance, and why the present moment was designed for their services. A quick google reveals that a variant of the phrase ‘is this active’s moment to shine?’ has been penned by some asset manager or other every few months, for years. So it's likely you have heard something like this yarn before. But a confluence of factors, including shifting monetary and geopolitical sands, stock market composition and a new-found appreciation of values-based investing, mean things may really be different this time.

The following, in a nutshell, is how that argument looks today – and how investors might respond to it.

What just happened?

In markets, no-one ever entirely knows where we are heading. But following a dizzying few years, we have a good idea of what just happened.

From around 1981, global markets’ risk rate of choice – the yield on 10-year US Treasuries – started to decline. Although there were plenty of bumps along the road, as interest rates, crises and booms waxed and waned, yields kept falling until they effectively dropped to zero during the Covid-19 pandemic. As the global economy opened up, inflation soared and central banks including the Federal Reserve dramatically lifted interest rates, sending yields back up to 5 per cent this autumn. With this shift, a new chapter began.

But yield comparisons aside, why would this matter for equity investors? The answer lies in the cumulative impacts of more than a generation of continuously cheaper capital, falling volatility, increasingly high levels of risk tolerance, and an ever more relaxed approach to stretched valuations.

Indeed, according to a recent paper by the Federal Reserve, 42 per cent of overall profit growth in the US market between 1989 and 2019 was “due to the decline in relative interest expenses and effective corporate tax rates”.

“Those risk rates declined more or less consistently for four decades and have served as a rising tide that lifted all or most equity boats, regardless of their quality,” says Dan Peris, an income-focused fund manager at Federated Hermes and author of the forthcoming book The Ownership Dividend. “So, rates begin falling at the same time as passive takes off. Those two phenomena mean that the ability to differentiate among companies dramatically decreases.”

If differentiation once again matters, that could be better news for stockpickers. In a recent report on the future of the industry, professional body CFA UK outlined a similar scenario in which the end of cheap money would result in a “largely benign” environment for active strategies. “With markets receiving less support from central banks, valuations become more differentiated, creating opportunities for stockpickers and value investors,” the report argued.

For a long time, differentiation hasn’t mattered. Unless, of course, you only invested in the world’s largest companies – which is to say a handful of the largest US technology companies. Because passive investing overweights these stocks in stock portfolios (by buying in proportion to their size), their huge success has been magnified, massively raising the benchmark for ‘market’ returns. Even this year, the average stock in the ‘Magnificent Seven’ grouping of Apple (US:AAPL), Amazon (US:AMZN), Alphabet (US:GOOGL), Nvidia (US:NVDA), Meta (US:META), Microsoft (US:MSFT) and Tesla (US:TSLA) has doubled in value, versus the 8 per cent return for an equal-weight version of the S&P 500.

In the equal-weight version of the index, the pack accounts for 1.6 per cent. Weighted by market capitalisation, it’s 27 per cent.

Although these stocks owe a lot of their historic returns to falling rates, we shouldn’t overlook their underlying business strengths, founded on our ever-strengthening adoption of technology, and powered by their huge economies of scale, branding and unchecked market dominance.

But while the endurance of Microsoft shows that colossal size, profit growth and momentum can coexist, growth for a $3tn company requires ever-trickier decisions around capital spending, innovation and strategy. It also requires solid market expansion and limited competition. Amazon, to cite one example from the group, already appears to be hitting hard boundaries in its largest division. Having built what we know as ecommerce, its ability to both expand its total addressable market and find above-average returns on capital is getting harder.

Certainly, nothing attracts the brickbats like a place on the podium. But all companies eventually struggle to maintain above-average growth. If that happens in the coming years, and the valuations of the world’s largest and most hyped stocks start to normalise, then prices will face pressure. When deciding to diverge from the market, this is one of the first places the active investor has to consider.

Another by-product of the falling risk rate era was a heightened focus on fees. In one sense, this looks like a chicken and egg problem; was it passive’s superior returns or lower costs that put it in front of active? Whatever the answer, an era of higher rates will inevitably lessen the focus on fees as higher discount rates come to occupy a greater relative role in the return equation.

Added to this, passive’s relative value for money cannot keep on improving indefinitely. In both the US and Europe, active mutual funds’ average fees declined more in absolute terms than they did for passives in the decade to 2021. And while they can clearly fall further, the costs on some passive products are approaching their limit. “Unless Vanguard wants to start paying customers 20bps to own the S&P, the tailwind of lesser fees is over”, asserts one active manager. “Free does appear to be a hard boundary.”

That’s not all

Monetary policy (and its attendant market impacts) isn’t the only ‘big picture’ unravelling. At the same time, many query whether the post-1981 corporate backcloth holds.

That’s because while capital was getting cheaper and risk rates were falling, so were overheads. Thanks to globalisation, which allowed continent-hopping businesses to string together the lowest input costs and tax structures across increasingly complex supply chains, profit margins reached an all-time high. Today, while we continue to live in a global economy, a multi-polar political order is fracturing a paradigm that for decades smoothed many companies’ strategic thinking.

“That framework had made it easy for companies to outsource everything and optimize their earnings per share,” notes Peris, who now sees a much more difficult world facing corporates. “Do you friend-shore or near-shore? How do you treat human capital? [W]ith the default business model no longer valid, you’re going to see greater variance in business outcomes, and a new premium emerging for good business decision-making.”

This isn’t the only area in which premia for hitherto overlooked (or under-weighted) companies might emerge. Arguably, this may already be a feature of the UK market. In the FTSE All-Share, for example, a heavy weighting to sectors that lack much control over their profits – such as oil and gas, mining, insurance or retail banking – has long made ‘buying the index’ a mixed blessing. In a different vein, debacles like CAB Payments (CABP), the business payments processing and forex group that has lost more than four-fifths of its value since its July IPO, serve to highlight the risks of an automated approach to buying the index.

Meanwhile, values investing is not going away. If the ESG debate means anything to the active question, it is that there is a group of investors for whom purpose trumps profit, and that it is very hard to ‘codify’ ethics with passive products. Indeed, as Vanguard’s withdrawal from the Net Zero Asset Managers initiative highlights, the ethos of passive ownership is at loggerheads with shareholder activism.

So now what?

If all of the above points to a less certain outlook for markets and business, and a lower likelihood for a sustained bull market in the next few years, then it makes sense to look for historical parallels in which equities struggled for direction.

Since the dawn of financial markets, such periods have been common. These are known as ‘sideways’ markets – sometimes described as ‘cowardly lion’ in sentiment, in contrast to both bulls and bears – and which often weighs heavily on equity returns, particularly if accompanied by a brief bear market in stocks.

Historically, there have been plenty of periods where stocks lagged bonds. Between 1966 and 1982, for example, US stocks barely outperformed long-term bonds, and were beaten by Treasury bills. Throughout this period – as with today, but in contrast to much of the past 40 years – the opportunity cost of being invested in fixed income was much lower.

As the investor Vitaliy Katsenelson writes in the excellent Little Book of Sideways Markets, when bullishness is in short supply, one of the most important points of focus for investors should be the earnings multiple. If expansion (or maintenance) of the price/earnings ratio cannot be relied on as a source of stock returns, then investors need to think more critically about a company’s source of returns, whether that comes from growth in corporate profits or dividends. Unfortunately for passive investing, at the level of the market, it isn’t possible to do this: you get what you are given.

“During sideways markets, all stocks don't dominate fixed income instruments; only the right stocks do,” writes Katsenelson. “A finely tuned actively managed portfolio will have the best shot at outperforming bonds and short-term securities over the course of a sideways market.”

And how to fine-tune that portfolio? According to the CFA report, “increased differentiation of valuations creates opportunities for stockpickers and value investors”. A November 2022 paper from T Rowe Price, one of the active asset managers on the receiving end of net outflows in recent years, also made the case for the return of “valuation and underlying earnings quality” as the main factors driving stock prices.

Another corollary of greater dispersion is that ‘thematic investing’ – that passive-cloaked-as-active financial product set – should matter less. If the tide is no longer rising, then participation in a market won’t be enough. Instead, it is a sector’s winners that investors should think about.

So is this active’s time?

Some early signs even suggest the active fight back is already on, albeit from a modest base. Morningstar found that 37 per cent of European active managers surpassed the average passive fund in the year to June, up from 34 per cent in the 2022 calendar year and 30 per cent in the 12 months to June 2021.

Could this all prove hot air? It’s quite possible. Even in a world of wider dispersion, separating winners from losers won’t be easy. Unlike investing in bonds and credit, which is a discriminatory process focused on minimising losses from definable contracted cash flows, buying equities will always be about maximising cash returns from those far less certain, and highly variable, projected returns on equity.

Still, this doesn’t mean we should continue to view passive as a near certain bet.

This week, in its 2024 outlook, the BlackRock Investment Institute stated its belief that an “active approach to managing investment portfolios will carry greater rewards” in the emerging market regime of higher volatility, uncertainty and dispersion of returns. Moving away from relying on the “one and done” asset allocation strategies that worked so well during our recent era of low inflation and volatility.

If the king of passives is highlighting the value of active investing, then maybe it’s time for a rethink.