Rather than being bitter at index funds, they say they look for mispricings

By Simon Constable 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (May 7, 2018).

Since the financial crisis there has been a consistent mantra around investing: Low-cost index funds makes the most sense because they are generally cheaper and perform better over long periods than mutual funds managed by stock pickers.

But now, some active managers are taking a new tack in making the case for their approach: They say the popularity of indexing, along with other changes in the market, is making it easier for them to find mispriced securities, resulting in a more fertile environment for stock picking than they've had in years.

"When markets [were] moving up like a rocket ship, it paid to have the cheapest exposure," says Joe Amato, chief investment officer at money-management company Neuberger Berman, acknowledging that in recent years the investing planets were aligned better for passive low-cost funds. During that period, the easy availability of credit ushered in by the Federal Reserve meant that many highly indebted companies could stay in business, he says. Buying high-quality companies didn't matter as much, and there was little price dispersion between individual stocks, he adds.

Then things changed. The Fed started to unwind its bond-buying program and began raising the benchmark federal-funds rate. The interest rate on the 10-year Treasury note has jumped.

Amid higher borrowing costs, price differences between lagging stocks and the top-performing ones have widened, Mr. Amato says, creating more opportunities for portfolio managers to find bargains.

Bargains to be had

Although it has been five years since even half of actively managed U.S. stock funds outperformed their benchmarks, their performance is improving. According to data from Morningstar Inc., 53% of such funds beat their benchmarks in the first four months of this year, up from 49% last year and 29% in 2016.

And while investors continued to pull money from actively managed U.S. stock funds in the 12 months through February, the outflows slowed by 15% compared with the year-earlier period, the Morningstar data show.

More active managers are beating their benchmarks; typically it is done by veering outside the index, says Ben Johnson, director of global ETF research at Morningstar.

Other money managers agree there are more bargains to be had now, especially among smaller stocks that aren't included in the major indexes tracked by large ETFs. Last year, 63% of active small-cap growth funds and 54% of active small-cap value funds beat their benchmarks, up from 29% and 18%, respectively, in 2016, according to Morningstar data.

"The money that goes into the passive indexes tends to gravitate toward the S&P 500," says George Young, a portfolio manager at Villere Balanced Fund in New Orleans.

SPDR S&P 500 ETF, for example, is the largest and most actively traded security in the world. The result is that large-cap stocks get bid up in price because of the massive flows into such ETFs, while smaller stocks often stay cheaper, Mr. Young says.

"We own Howard Hughes [Corp.]," he says. The $5 billion real-estate firm trades at less than twice book value, he says, compared with 13 times book value for the $50 billion Simon Property Group Inc.

Skepticism remains

Of course, plenty of experts aren't buying the argument that stock pickers are making.

"I hear people say that now is a good time for active management, but I believe it is becoming extinct," says Mitch Tuchman, managing director at Rebalance IRA in Palo Alto, Calif. Compared with the stock-picking heyday before the 2007-09 recession, it is now devilishly tricky to succeed in active fund management, he says.

"Today when you find something mispriced, others find out the same things very quickly," he says. "The time frames are shortened," in part due to technology. The speed of the market means managers often don't have long enough to build positions of sufficient size to make a meaningful difference in their fund's performance, he says.

Still, Mr. Amato says bets on mispriced securities have paid off for his firm in recent years, including one on Goldman Sachs Group in 2016. Goldman shares had slumped around 20% in June 2016 after a decline in commodities prices to a multiyear low earlier in the year dragged down stocks and bonds.

"We saw an outstanding team, with the willingness to right-size the operation," says Mr. Amato. "We also had confidence in their investment-banking franchise." In short, he says his team thought the bank would eventually out-compete its second-tier competitors. As of May 1, the stock had rebounded around 70% from its June 2016 low.

Similarly, Craig Hodges, chief investment officer at the Hodges Funds, says his firm took advantage when a drop in oil prices a few years ago crushed shares of United Rentals, which in addition to serving industrial customers also provides equipment to petrochemical businesses. During the oil-price rout, the price of the stock fell by more than half, "yet earnings estimates hardly moved," Mr. Hodges says. "The energy bust didn't fundamentally hurt their business."

Since early 2016, the stock has more than tripled.

Mr. Constable is a writer in Edinburgh, Scotland. He can be reached at reports@wsj.com.

 

(END) Dow Jones Newswires

May 07, 2018 02:47 ET (06:47 GMT)

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