Maligned stock pickers catch up to index funds. Can it last?

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 percent 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 percent 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. 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. 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. 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. 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 percent of managers in the largest category of mutual funds have beaten index funds. In some areas of the market, active managers have had a better track record. Over the last decade, 44 percent 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 percent. 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.