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Time to Rethink Role of Active Management?

Active managers have had a rough time in the years following the 2008 financial crisis, but things are looking more favorable for stock pickers. With that in mind, financial advisors may want to rethink their views on the age-old debate over active versus passive management.

Active managers’ woes were particularly acute in 2011, when approximately only 35% of stock pickers outperformed. Since then more managers have been beating their benchmarks.

Yet, the overall success rate is still at approximately 45% as of 2013, which is substantially below the 55% rate of 2007, according to a Morgan Stanley research note. With fewer than half of managers beating their benchmarks, it’s tempting to dismiss active management in favor of indexing,. However, with changing market conditions, more managers are likely to outperform, so advisors may want to examine whether it makes sense to increase their asset allocations to stock pickers.

At the same time, advisors who have embraced active management should understand broad trends in markets that have impacted stock pickers as clients may question the merits of having rejected index-based products.

Broadly speaking, managers have struggled in recent years with high correlations among equities, underperformance of small-cap stocks, and lagging returns of international companies. During most economic recoveries, most companies are able to grow their earnings.

As their earnings improve, investors go on a buying spree, driving up stock prices. As economic recoveries mature, however, the variation in earnings growth among leading companies and second-tier businesses widens. Active managers with a research-driven investment strategy, in theory, should be able to identify companies with the best potential to grow their earnings and therefore reward investors because their stocks are likely to outperform stocks of less successful corporations.

In a similar manner, rising interest rates could cause correlations among equities to decline. That’s because leading companies will be able to grow their revenues, which will help counter the impact of higher financing costs on earnings. Less successful companies, unfortunately, will be more susceptible to the adverse impact of higher financing costs. While inflation has been virtually non-existence and labor wages have been flat, it’s just a matter of time before the Federal Reserve starts to raise interest rates.

Many managers have also underperformed because they have maintained a small-cap portfolio bias. That was beneficial in 2013 when small-caps soared, but it created a major drag on returns last year. More recently, however, the U.S. dollar has been strengthening, which is making American exports more expensive in foreign markets.

Economic weakness abroad, meanwhile, is causing a decline in exports to foreign markets. Importantly, bigger companies tend to generate a larger portion of their revenues abroad, so they are more susceptible to the rise of the U.S. dollar and economic weakness aboard than smaller companies. As a result, smaller-cap stocks may outperform this year, which would give active managers a notable advantage.

Also during the past few years, many active managers have maintained exposure to non-U.S. companies that are positioned to benefit from rapid growth in foreign economies. Yet, that strategy has generated poor results as economic growth in Europe, Japan, and emerging markets has disappointed.

While conditions abroad may not improve in the near term, economic growth is likely to improve over time. Japan and Europe, for example, have announced unprecedented stimulus programs, including U.S.-style quantitative easing, that should eventually boost economic growth and provide fertile grounds for foreign companies to grow their earnings.

For financial advisors, the shifting winds for active managers have a variety of consequences. Advisors who have recommended actively managed products may want to explain to clients that the use of stock pickers, while being disappointing in recent years, now has increased potential for generating attractive investment returns.

The argument can be highly relevant when clients complain about the underperformance of their actively managed funds. Advisors who are staunch advocates of passive management may also want to rethink their investing strategy. For example, it may make sense to adopt a core and satellite strategy that involves allocating the bulk of a portfolio, or core, to index products and using specialty active funds, such as small-cap or international, for smaller allocations to enhance returns.

Broadly speaking, such an approach typically uses satellite allocations, or the smaller allocation, for exposure to less efficient asset categories, such as small caps and emerging markets, that provide more opportunities for active managers to outperform.

Regardless of advisors’ perspectives on portfolio management, understanding how conditions are changing for stock pickers and being able to explain the changes to clients is crucial as it can help advisors illustrate that they are in touch with market conditions.

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