It's Never a Stock Picker's Market
These days you hear a lot of people claiming that it’s a “stock picker’s market.” A drop in correlations, in which stocks as a group rise, and the apparent end of the steady bull market of the last several years has some people anticipating a comeback for active investment management. Even Josh Brown, an inveterate enemy of active investing, caught a little bit of the fever.
But don’t bet the farm on a return to active management. All the old drivers behind the shift to passive management are still in full force, and there are some new ones too.
First of all, there are some broad currents working against stock-pickers. Many of them blame the Federal Reserve's easy money policies for their poor recent performance. Correlations dipped last year but are rising again. My Bloomberg View colleague Justin Fox says that it looks like the world is “out to get” active managers.
Fox also flags another, more ominous factor. A recent book by Larry Swedroe, entitled "The Incredible Shrinking Alpha," points out that with the shift of dumb money to passive management, there are fewer chumps for the pros to pick off. That is surely going to be important.
But I believe that Fox and company, although they are certainly right, may be missing the forest for the trees. Yes, macro forces are important. Yes, Swedroe has a great point, and his book is rightfully causing a lot of angst in the industry. But there is a bigger, deeper reason why it isn't time to hand your money over to a stock picker. If the idea that it's a stock picker’s market means that stock pickers will make money for you, the investor, then it’s never been a stock picker’s market.
This isn't to say that stock pickers have no skill. They do. Contrary to what you may have heard, there is evidence that professional stock pickers managed to beat the market throughout much of history. Skill is real, and success is not just a matter of luck.
There’s just one problem -- even when they beat the market, stock pickers charged so much in fees that their investors ended up underperforming passive benchmarks. The blunt fact is that even before the rise of exchange-traded funds and index funds, stock pickers never made much money for their clients. This is similar to what Simon A. Lack, author of the book, "The Hedge Fund Mirage," has found for hedge funds.
The basic conundrum is this: if a stock picker knows how to beat the market, why should he let you, the investor, take a cut of the profits? After all, every successful stock picker’s technique is unique, or close to it -- if it weren’t, then their so-called alpha (above-market returns) could be replicated by a simple benchmark and relabeled as beta (market-matching returns). So if you, the investor, jump ship because your manager’s fee is eating up all the profit he makes from beating the market, you’re not going to be able to replace him very easily. So the manager has no reason not to take all the gains in the form of fees.
There’s also a second problem. The more assets you manage, the harder it is to beat the market, since the fewer inefficiencies there are to be exploited. When an asset manager does manage to beat the market, large amounts of investor money flow his way, as you might expect. But this drives down his return, meaning that even if his skill is good, he exhibits regression to the mean. Success is self-defeating.
What this means is that giving your money to stock pickers was probably never a good idea. Unsophisticated investors’ shift into passive management is a rational, if long-delayed, response to the flood of data demonstrating this fact. And as Swedroe points out, that shift will only make it harder for stock pickers to beat the market, even before fees.
In other words, don’t expect 2015 to herald a new dawn for stock pickers, no matter what happens to volume, volatility, Fed policies and correlations.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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