Best Stock Pickers Say Easy Money Has Made Their Job HarderCharles Stein
Robert D’Alelio has the kind of long-term record every mutual fund manager aspires to, beating 98 percent of his peers over the past 15 years with the $12.6 billion Neuberger Berman Genesis Fund and crushing his benchmark, the Russell 2000 Index.
D’Alelio’s performance over the past five years isn’t so enviable. He’s fallen behind his yardstick, and he’s got lots of company. Stock pickers including Donald Yacktman at the AMG Yacktman Fund and the team of O. Mason Hawkins and G. Staley Cates at the Longleaf Partners Fund trailed their barometers in the same period after dominating in the prior decade.
Managers say they haven’t changed, the market has. The easy money climate of near-zero interest rates engineered by the Federal Reserve has artificially inflated prices of lower-quality U.S. stocks, they say, punishing those who focus on businesses with the best fundamentals. At the same time, the relentless climb of prices across equity markets has left them with few chances to sniff out bargains or show what they can do in more-volatile times.
“In straight-up markets you don’t need active managers,” D’Alelio said in a telephone interview. “If the next five years are the same, there won’t be any active managers left.”
Twenty percent of mutual funds that pick U.S. stocks beat their main benchmarks in 2014, and 21 percent topped the indexes in the five years ended Dec. 31, according to data from Chicago-based Morningstar Inc. Over 10 and 15 years, the winners rise to 34 percent and 58 percent, respectively.
Investors have expressed their displeasure by moving money to low-cost funds that mimic indexes. In 2014, actively run U.S. stock funds suffered $98 billion in redemptions, while index funds took in $167 billion. Passive managers represent 38 percent of the $8.7 trillion stock fund business, more than twice their share 10 years earlier, Morningstar data show.
The shift may be ill-timed if the herd mentality comes to an end. Lagging behind the market will motivate managers to change their investment process and common sense will prevail as the economic cycle ages and fundamentals are rewarded, Brian Belski, chief investment strategist at BMO Capital Markets, wrote in the firm’s 2015 outlook published in December.
“From our lens, this means a prolonged period of active investing is upon us, thereby overtaking the macro or index biased ways that have engulfed investing the past 15 years,” Belski wrote.
Royce Funds, the small-cap stock unit of Baltimore-based Legg Mason Inc., is undeterred after more than $17 billion in redemptions during the past four years. The $4.9 billion Royce Premier Fund beat 97 percent of rivals over 15 years, a number that drops to 7 percent over five years, Morningstar data show.
“We have been using the same process to pick stocks for 40 years and we have confidence in it,” Frank Gannon, co-chief investment officer for Royce, said in a telephone interview.
In his view, the Fed keeping interest rates near zero for the past six years has had the “unintended consequence” of boosting the stocks of companies with heavy debt and little or no earnings.
Typically after a recession, such companies lose out to firms that generate more cash and have better balance sheets. This time, no “Darwinian” shakeout happened and low-quality stocks ruled, Gannon said.
“There has certainly been little reward for owning high-return, superior business models that are conservatively financed,” Neuberger Berman’s small-cap stock team wrote in an October 2013 paper titled “Is There Hope for Active Managers?”
Stocks have moved in lockstep to an unusual degree since the 2008 financial crisis, a handicap for managers seeking to exploit market inefficiencies.
Monthly dispersion among Standard & Poor’s 500 Index members, a measure of how far individual stocks are swinging relative to the market, narrowed for a fifth year in 2014 and in August reached the lowest level since 1979, data compiled by JPMorgan Chase & Co. and Bloomberg show.
As stocks started moving more on their own this year, 46 percent of active managers were beating their benchmarks as of Jan. 31, according to Morningstar.
Regardless of whether the trend is turning, Jeff Tjornehoj, an analyst with Denver-based fund tracker Lipper, doesn’t buy the idea that certain types of markets are tougher on stock pickers.
“It sounds like a team complaining about the rain when everyone has to play under the same weather,” Tjornehoj said in a phone interview.
Jim Rowley, a senior analyst at Vanguard Group Inc., is also dubious of high stock correlation as an explanation. In each of the last eight years, at least 70 percent of the stocks in the broad Russell 3000 Index either beat or underperformed that benchmark by 10 percentage points or more, according to Rowley, whose firm is known for championing index funds.
“That would suggest there has been ample opportunity to pick winners and losers,” Rowley said in a phone interview.
Stock pickers also complain that markets have essentially gone up for six consecutive years, excepting a flat 2011.
“People speak as if we have gone through a whole cycle,” said Neuberger’s D’Alelio. “Show me a cycle where stocks go straight up with no corrections.”
The lack of market corrections has hurt Yacktman, who in 2009 was a finalist for Morningstar’s manager of the decade award.
“A lot of our outperformance comes in difficult environments,” said Jason Subotky, a co-manager on the $13.9 billion AMG Yacktman Fund and the $10.9 billion AMG Yacktman Focused Fund.
The Yacktman Fund, after beating competitors in the market selloffs of 2002 and 2008, has averaged annual returns of more than 13 percent in the past 15 calendar years, handily beating the S&P 500.
Over the past five years, the fund trails the benchmark. Investors withdrew $1.7 billion in 2014, according to Morningstar estimates.
The current market is reminiscent of the late 1990s, say Hawkins and Cates, who have overseen the $7.5 billion Longleaf Partners Fund for more than two decades and still have a top 15-year record.
Then, as now, stocks marched higher “while fundamentals mattered little,” the pair told shareholders in a January letter. Once the dot-com bubble burst in 2000, stock pickers eventually regained favor.
“At this moment of relative weak performance with active management in disrepute, our optimism about future relative performance is exceptionally high,” the two wrote.
Others who have cooled off say their approach will win the day again, whenever that day comes.
“History shows that sticking to your discipline is a good thing to do,” said Eric Schoenstein, who is part of the team running the $5.6 billion Jensen Quality Growth Fund.
“This is setting up as an ideal environment for stock pickers,” said Neuberger’s D’Alelio.