Newsletter author Michael Brush explored a topic of interest to SMI readers yesterday in his MarketWatch column, "Active Money Managers Are Now Despised — Which Is Why You Should Buy Their Stocks."
The article is primarily about the stock of six active-management companies that Brush thinks are undervalued, and thus are attractive purchase candidates. But the aspect that's of particular interest to SMI readers is why Brush believes they are undervalued in the first place.
Brush briefly builds a case as to why active management (of all types) has had such a tough run over the past decade but points out, "Trends play out in cycles in the markets, and sooner or later active managers will show their worth again." He then presents the following reasons as to why the active/passive management cycle seems poised to turn back in favor of active management soon:
• QE finally fades. Sooner or later the Fed will launch a plan to taper quantitative easing that doesn’t frighten investors into throwing a temper tantrum. So the taper plan will persist. At that point the entire market dynamic will change because stocks won’t go up in unison anymore. Stock picking will matter again.
“It’s hard to beat the S&P 500 when everything is going straight up,” says George Putnam, an active manager who pens The Turnaround Letter.... “But I don’t think that is going to continue for the next five years.”
“Indexing has been fantastic during the QE era because you didn’t have to be smart, you just had to be in,” says Kelley Wright, who pens a value-oriented stock letter called Investment Quality Trends. As QE eventually fades we’ll “enter a new trend where you actually have to be smart and know how to pick stocks,” he says.
• Volatility comes back and stays around a bit longer. We got a taste of how nasty the market can be to investors last winter. Many self-guided investors tend to be too emotional, too ill-informed, and too inexperienced to know how (or whether) to ride it out. Professional money managers are better at this.
“Advisors prove their worth by having a disciplined and unemotional approach that allows investors to participate in the gains even if they don’t beat the S&P 500,” says John Buckingham, an active manager who edits The Prudent Speculator stock letter.
A phase of continued volatility would shake out the self-guided investors and send them back to active managers for safety — and hand holding if their accounts are big enough.
• A recession arrives. This will create a bear market and sustained losses that will have self-guided investors throwing in the towel and putting their money into managed funds. “The next time we have major correction and investors get killed in their index ETFs, they are going to say ‘I have to do something different,’” says Wright. Leaving the driving to professional money managers might be the trick.
Brush acknowledges that the "When?" part of all this is, as always, hard to pin down. But he says, "We are definitely closer to the end of this economic cycle than the beginning."
Interestingly enough, just a day after this article was published, the first company on his list, Oaktree Capital Group (the firm of Howard Marks, who SMI has excerpted articles from in the past) was acquired by another investment firm. That's a good indication that Brush's thesis — these stocks are being cheaply valued at present — is accurate.
SMI has been nervous for some time now about how the legion of investors who have joined the index-fund bandwagon over the course of this bull market is going to cope with the next bear market. When Will the Clock Run Out on the Indexing Advantage? was asking these questions more than four years ago, and the draw of indexing has only grown more pronounced with every additional year this record-setting bull market has tacked on. As I discussed in our March Editorial, while most index investors consider themselves to be buy-and-hold investors, our experience is that many don't actually survive significant bear markets, instead selling at significant losses and crippling their long-term results.
Diversifying between strategies is something SMI has encouraged for decades, going back to the days when our only strategies were Just-the-Basics (indexing/passive management) and Fund Upgrading (active management). So we're not anti-indexing by any means — indexing can be a smart part of an overall investing plan. But we are concerned, given the huge swing over the past decade from active to passive, that many indexers who haven't owned index funds in a bear market before may be utterly unprepared for what's coming.
Active strategies such as Upgrading 2.0 and DAA can be frustrating when they trail the indexes during bull markets, or flip on-and-off as they sometimes do around market turning points. But they're worth their weight in gold when bear markets ultimately arrive, holding on to most of their hard-earned gains while indexers see much of theirs slip away.