All those headlines about new stock market highs may look sexy, but life for active managers hasn't been quite so much fun.This shouldn't surprise us, even hot hedge funds are struggling this year. Why are active managers severely underperforming yet again? You know my thoughts already. Just like hedge funds, the bulk of mutual funds stink, getting paid fees for being closet indexers and worse still, for underperforming their index.
In fact, running large-cap mutual funds has been a rough business, with about 80 percent underperforming the S&P 500 in 2014, according to S&P Capital IQ Fund Research. That's four out of five managers who've failed to match a simple stock market index fund that usually has lower fees and other advantages.
There are a handful of explanations for why performance has been so weak this year, but at the core seems to be the general and stunningly persistent belief that the market remains ahead of itself, with danger always right around the corner. Fear of a looming correction has kept many investors playing defense.
"We've gone 35 months without a decline of 10 percent or more, and the median since World War II is 12 months," said Sam Stovall, S&P's chief equity strategist. "Everybody seems to be waiting for that all-elusive correction, when everyone will pile in. But if everybody's waiting for it, it won't happen."
Stovall believes the trouble active managers have had actually could feed into the market rally. As the year winds down, managers may begin to chase performance, taking on more risk or actively seeking out poorly performing sectors such as small-cap stocks.
"If they underperform by too much, they don't get their bonus," he said. "With 80 percent underperforming vs. the more normal 73 percent, you have a greater number of fund managers who are going to feel like they've got to really turn in the afterburners to hopefully outpace the market by the end of the year."
There is, however, a bit of a silver lining in the troubles for active managers.
Todd Schoenberger, president of J. Streicher Asset Management, said the underperformance actually is indicative that managers are prudently reducing risk during an aging market rally.
"If you have a portfolio manager who's knocking the ball out of the park and hitting grand slams, doing amazing performance, the investor should always ask what is the amount of risk being taken to achieve that number," he said. "If you have a portfolio manager making 30 percent, there's a solid chance they can lose 30 percent. The portfolio managers, even though they're lagging the averages, they're probably doing the prudent thing in managing risk."
Active management has lagged in the years since the financial crisis—ever since the Federal Reserve employed a historically strong intervention into financial markets and stocks have operated on a risk-on risk-off mode, with correlations high and little place else to go for return but equities.
Investors have flocked from mutual funds since the crisis, though at least in terms of money flows 2013 and 2014 have been better years.
The exchange-traded fund industry, which uses passively managed low-cost index funds, has exploded to $1.81 trillion under management, a 20 percent gain over just the past 12 months, according to the Investment Company Institute. The $15.7 trillion industry has grown 14.8 percent in the 12-month period—respectable, for sure, but behind ETFs.
Doug Roberts at Channel Capital Research believes extreme central bank easing has made it tougher on active managers.
"Once you have everything going up, it's really difficult for an active manager to outperform," he said. "He has to be right on the mark. He has to get into something that not only has good long-term fundamentals but also is at an inflection point. That's no small task."
The fact is many active managers continue to misread the macro environment and instead of cranking up risk, they're reducing risk by raising cash, preparing for another stock market crash that is unlikely to happen anytime soon as this rally keeps surprising the staunchest bears and bulls.
And as I've warned all of you recently, the real risk in the stock market is another melt-up unlike anything you've ever seen before. In that comment, I warned that the endgame is deflation but before that, we'll get a massive liquidity-driven rally in risk assets, ending my comment with this stark warning:
...remember the wise words of John Maynard Keynes, "markets can stay irrational longer than you can stay solvent." The events I'm describing above won't happen in the next year or even five years. So while the Zero Hedge bears keep posting scary clips, relax and mark my words, the real risk in the stock market is a melt-up, not a meltdown, and institutions betting on another crash will get clobbered.It seems like the folks at Morgan Stanley agree with me as they now see this market rallying for another five years. Of course, we all take these prognostications with a shaker of salt as a lot of things can derail this endless rally, especially bad news out of Europe which is at risk of a total collapse.
But have a look at the 10 best and worst S&P 500 stocks of 2014, and you'll be surprised by some names (click on images below):
And the worst S&P performers:
I foresee a lot of of mutual funds and hedge funds will be chasing the winners in the last quarter of the year. What else do I foresee? The high octane momentum stocks that got crushed in Q1 are coming back to life and will severely outperform the S&P 500 in Q4. For example, check out the recent action in Splunk (SPLK) and FirEye (FEYE). And nothing seems to be stopping Tesla's (TSLA) or Netflix's (NFLX) momentum for now. There are other momentum darlings like GoPro (GPRO) ripping higher as momos chase the next big thing.
I still love Twitter (TWTR) and think it can easily double from these levels. Also, biotechs continue to drive the broad market rally, so pay attention to large cap names and some small cap biotechs I recently mentioned here.
Below, Wharton School Professor of Finance Jeremy Siegel has been bullish on the stock market for years now and he's not ready to change his mind yet. But he introduced a caveat Tuesday on CNBC: "We are creeping closer to fair market value [for stocks], which I think is approximately 18 times S&P earnings."
As I've repeatedly warned you, the big risk right now is stocks going parabolic, especially if the ECB engages in quantitative easing on Thursday. That will ignite another fire under global equities and other risk assets. Stay tuned, it should be an entertaining final quarter of the year and I think a lot of underperformers are going to be chasing stocks higher going into year-end.