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Wednesday, January 5, 2011

A Better Market for Active Fund Managers in 2011...or an Even Worse One

A WSJ blog reports on research from (surprise) Merrill Lynch that the future will be better for active managers than it was last year:

Active Managers in 2011: A Wheat/Chaff Moment?

December’s 6.5% melt-up on the S&P 500 caught a lot of investors by surprise, not least of which were active managers. According to numbers put out by Bank of America-Merrill Lynch yesterday, 39% of actively-managed funds beat the market in December — not bad, but lower than the 44% that beat in November.

A fortune report on the merrill reseach notes it was one of the worst year's ever for active managers


Entering December, a quarter of funds were running ahead of their benchmark indexes, Subramanian writes Tuesday in a note to clients. But another dismal month, with fewer than half of managers beating their bogies, took that number down to a dismal 20% by year-end.
yet amazingly the merrill research report argues:

With a new year upon us, and the economic recovery back on track (fingers crossed), this may be the moment to separate the wheat from the chaff, as far as active stock pickers go. With stock clustering starting to wane, good companies will likely be freer to rise on their own fundamental strengths — and weak companies more likely to fall on their inherent weaknesses. In BAML’s parlance, then, this is the year stock pickers “make a comeback,”
indeed hope springs eternal



The evidence for the above is pretty slim as it is based on a small decrease in correlation between stocks of late (and the active managers didn't have much better success during that period). In fact, the longer trend: the growth of  high speed intra day trading  and the growth of etfs which means at a minimum a high correlation of stocks within industries if not the overall market, argues the cross correlation of stocks will continue.And this can only mean a more difficult market for active managers going forward rather than a better one.

Seems whatever the short term decline in correlation the long term trend is clear. From cnbc website

Investing Dying as Computer Trading, ETFs & Dark Pools Proliferate

There's an old Wall Street adage meant to inspire investors that goes "it's not a stock market, but a market of stocks." Consider that dead.
Computer trading, dark pools and exchange-traded funds are dominating market action on a daily basis, statistics show, killing the buy and hold philosophy still attempted by many professional and retail investors alike. Everything moves up or down together at a speed faster than which a normal person can react, traders said.
High frequency trading accounts for 70 percent of market volume on a daily basis, according to several traders' estimates.
The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology," said Alan Newman, author of the monthly newsletter. "HFT promises gains are best provided by holding periods measuring as few as microseconds, possibly a few minutes, or at worst, a few hours."

While individual investors must cede the intraday profits to the high speed traders, in my view it doesn't necessarily mean that a long term well diversified global portfolio suffers from these trends, After all if stocks are more correlated holding a broad basket for the long term should still be a viable strategy with lower fees and lower taxing helong the results.

.After all during an earlier period specialists, floor traders and institutional trading desks  in a slower trade environment profited from the daily trading flow (otherwise a seat on an exchange wouldn't have been a  valuable asset) Indivdual investors didnt get a piece of those profits either. So the more things change the more they stay the same: market makers extract a profit from providing liquidity.

In fact the argument below argues for etf portfolios rather than stock picking:

The problem is only made worst by the proliferation of exchange-traded funds, traders said. The vehicles, which make trading a group of stocks as easy as buying and selling an individual security, passed the $1 trillion in assets mark at the end of last year, according to BlackRock. This is probably why all ten sectors of the S&;P 500 finished in the black for two consecutive years, something that's only happened one other time since 1960, according to Bespoke Investment Group.
If the above has occurred for 2 consecutive years, why would there be any evidence to expect a "stock pickers" maket going forward. After all the growth of high speed trading and etfs in accelerating, not slowing.

This frustrating trend  for stock pickers is doubtless behind the latest "product" from the mutual fund industry: "alternative strategy, go anywhere funds."From the WSJ

In 2010, a growing number of companies offering actively managed mutual funds finally began to get creative in their efforts to halt the erosion of their business caused by low-cost, index-tracking exchange-traded funds....
The alternative funds are actively managed, too, but they aim to invest and perform differently from funds that hold standard investments like stocks or bonds or cash. Alternative funds may hold uncommon assets or use particular strategies that historically haven't moved in lock step with plain-vanilla investments. For instance, many of the alternative stock funds buy some shares in hopes they will rise, while also placing bets that other shares will fall in price.....
The fund companies have had success in marketing:
Investors seem to like the idea. The funds have taken in more than $22 billion in the past year, Morningstar says....
and they have been marketing them for good reason (for them):
One big reason the fund companies like alternative funds: They can charge much higher fees than they do for traditional funds because of the more complicated strategies, which can include sophisticated derivatives. The average management fee on alternative stock funds is 1.04%, compared with 0.62% on actively managed funds holding big-company U.S. stocks, according to Morningstar.
Of course etfs on broad market categories can be purchased with even lower fees...as low as .10%

The likelihood these funds will be better will perform better for investors than they do for the fund companies seems slim. If it is difficult to beat the market picking individual stocks I'm not sure it would be more difficult "going anywhere". Furthermore if the long term trend is for higher correlation across stocks in particular industries it would seem a particularly environment for the strategy of " "paired stocks" matching longs and shorts. Add in the higher fees and the hurdles to beat the indexed portfolio seems even higher.

And even the recent divergence among US stocks hardly argues for stock picking. Small stocks have diverged from large stocks recently, but a well diversified etf portfolio would have benedfited from this, without being dependent on individual stock selection

At the end of last year, something strange happened. After tracking the S&P 500 for most of 2010, the Russell 2000 Index, made up of many small companies with very different characteristics and merits, broke away in the final three months to double the gains of large cap benchmark for the year.
"Small cap outperformance in the last quarter is a very good sign this trend is ending," said Joshua Brown, money manager and author of The Reformed Broker blog. "Winners and losers are starting to separate themselves after a year of the whole risk-on (buy anything), risk off (sell everything) of the last year."
Of course, you could have just bought the iShares Russell 200 Index ETF (NYSEArca:IWM - News) in September.(or simply held them as part of a diversified portfolio all year benefiting when large and small stocks moved together and capturing the small stock outperformance.)

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