NEW YORK — Last year was a terrific one for nearly every stock investor as markets kept soaring higher. It was even better for one group that’s among the most maligned on Wall Street.
Mutual fund managers who pick stocks have fallen out of favor after years of underperforming funds that passively track a benchmark, such as the S&P 500 index. Investors showed their displeasure by yanking hundreds of billions of dollars from actively managed funds.
Last year, the stock pickers turned things around. Forty-three percent of U.S. stock fund managers beat their average index-fund peer in 2017, according to Morningstar, compared with a dismal 26% success rate the year before. While the market’s gains were strong and steady, stocks moved less like a herd, creating the opportunity for higher rewards for managers able to pick the right stocks.
This year, volatility has returned to the markets, including the first drop of 10% for the S&P 500 in roughly two years. As stocks sold off in February, most active managers delivered a steadying hand to their investors, with milder losses than index funds, by avoiding some of the hardest-hit areas. That fits with history: Actively-managed funds have tended to hold up better than index funds during down markets, which can be particularly valuable if it prevents investors from selling stocks at the bottom.
Still, the long-term data show that most active managers aren’t able to match the returns of index funds, which have the big advantage of charging lower fees. In the end, experts say, the clearest lesson from the data may be that finding a fund with low expenses should be the first task for investors. After that, consider whether you want an index fund or a manager who’s trying to beat the market.
An opportune upturn in performance
The calm ride higher for stocks was shattered in February when worries about higher inflation sent the S&P 500 to a loss of 10% in just nine days. Through the tumult, nearly 60% of all actively managed U.S. stock funds offered better returns than index funds, according to Morningstar.
Active managers say they do better in these kinds of markets because they’re not forced to buy whichever stocks are in the index at whatever proportions the index says — no matter how overvalued or unattractive analysts say they have become. That means they can avoid some of the worst areas of the market during downturns.
During last decade’s housing bubble, for example, financial stocks accounted for a fifth of S&P 500 index funds, more than any other sector. Those stocks were crushed by the financial crisis, and Lehman Brothers, Bear Stearns and other hallowed Wall Street names collapsed or were sold at fire-sale prices. The aftermath of the financial crisis was the last time the majority of actively managed U.S. stock funds was able to beat index funds over a three-year period, according to Morningstar.
Not only that, managers say they’re benefiting in particular now because stocks are moving to their own rhythms more often, rather than climbing and falling all together.
“It’s nice to see some volatility and the opportunity for individual stock selection,” said Lamar Villere, portfolio manager at Villere & Co. “When one of our stocks works, which is happening as of late, it makes a big difference, and investors are actually rewarding them instead of moving the entire market instead.”
The biggest stock investment in his Villere Balanced and Villere Equity funds, for example, is Axon Enterprise, the maker of Taser stun guns. It’s up 46 percent in 2018, versus less than 2 percent for the S&P 500, as of Wednesday’s close. “We’ve been having a lot of fun,” Villere said.
For the long run
Over the long term, up markets tend to last longer than down markets. Plus, the stock-picking managers who manage to beat the market in one downturn don’t always do so in the next one, according to Morningstar. That’s part of the reason why the majority of actively managed funds have failed to keep up with index funds over the long term.
Over the last 20 years, a span that includes not only the Great Recession but also the collapse of the dot-com bubble, only 13% of managers in the largest category of mutual funds have beaten index funds.
In some areas of the market, active managers do have had a better track record.
Over the last decade, 44% of all intermediate-term bond funds have beaten their average index-fund peer. Narrow the field down to the funds with the lowest expenses, and the success rate jumps to 64%. In recent years, the majority of emerging-market stock fund managers have also been beating index-fund peers.
Regardless, the best way for investors to improve their odds of success is to focus on the funds with the lowest expenses, said Ben Johnson, director of global ETF research at Morningstar. Funds that charge high expenses have to perform that much better than low-fee funds in order to deliver similar returns.
“If there’s one clear signal that comes through, it’s that probably the only reliable way to boost your odds of picking a winner in a crop of active managers is to narrow your search to those who are charging the lowest fees in a given category,” Johnson said.