SKARBECK: Active managers thrived in 2016’s strong market

Active investment management has been under fire in past years. Active management is the process where an investment manager selects individual securities with the goal of outperforming a market index (or benchmark). Think of active managers as money managers who make the decisions at mutual funds, hedge funds, some registered investment advisers, some brokers, and perhaps yourself—i.e. anyone who manages a portfolio of individual securities.

In recent years, investors have gradually begun drifting away from active management by moving more of their money to index funds and ETFs. The reason is that the net-of-fees performance of many active managers has failed to outperform a low-cost index fund. It’s been a tough stretch for mutual funds and hedge funds.

When mutual funds entered their heyday 25 years ago, the goal of most fund firms was to gather assets—attracting more assets meant more fee revenue. A combination of shrewd marketing, a raging bull market in the 1990s, and a growing middle class needing to save for retirement built these mutual fund firms into huge asset managers. Today, Fidelity manages over $2 trillion in assets.

The fund companies also found that, if their investment managers’ performance did not stray too far from the market index return, most investors would stick with them. The term “closet indexing” was coined to describe mutual funds that assembled portfolios to closely mimic the market or a benchmark return. Consider that a portfolio of five mutual funds may own close to 500 stocks.

Since the market crisis of 2008-2009, many mutual funds and hedge funds have struggled to even come close to the market’s performance. It took some time, but many investors began to realize that they were paying significant fees for investment results that lagged the market. Money began to shift to lower-cost index funds and ETFs.

This year, in contrast to that trend, a significant number of active managers will outperform the market. The post-election market frenzy has delivered some big winners for a variety of individual stocks—i.e. bank stocks have soared. Small stocks also are an area where active managers tend to beat the market, and in November alone the Russell 2000 index was up a stunning 11 percent. Thus, it appears many investment portfolios in 2016 will top the S&P 500 (with dividends reinvested), which has gained almost 10 percent.

While index funds are an easy and cheap way to earn the stock market return, investors need to be mindful that basic investing principles still apply. The best returns will come from investing when stocks are depressed and valuations low. Conversely, pouring into index funds at higher valuations will lead to modest long-term returns.

For investors who seek to outperform the stock market, active management’s focus on individual securities and the businesses behind them provides that opportunity. Yet success requires a certain temperament and an unconventional approach. The accepted investment principle of broad diversification cannot be followed.

The active investor must remain rational and unemotional, particularly in times of market stress. A dose of contrarianism that questions the norm is a good skill. In the end, a portfolio of 10 to 20 good businesses obtained at attractive valuations offer the opportunity to outperform the indexes over the long term.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at (317) 818-7827 or ken@aldebarancapital.com.