Phrases that consumers of financial media see and hear regularly are, “This is a stockpicker’s market”, or “Now is the time for active management”. It’s a particularly common refrain at the start of a new year. In January this year, for instance, Goldman Sachs
confidently declared: "We believe 2024 will be remembered as the ‘Year of the Stock Picker.’” It’s still too early to judge, but, as of now, the signs are that Goldman probably got it wrong.
So, what do these phrases actually mean? Are there really times when active management makes sense? Indeed, is there such a thing as a stockpicker's market at all?
These issues were the subject of a recent study by researchers at Vanguard. The question they set out to answer was this: Are there certain market conditions in which active managers are likely to perform best?
Volatility and dispersion
In theory, there are two main of types of conditions which are favourable to active managers — high volatility and high dispersion.
Volatility refers to the degree of variation in market prices over time. High volatility means larger price swings, while low volatility indicates more stable prices. High volatility presents active managers with the opportunity to profit from market timing — in other words, taking advantage of market ups and downs to buy and sell the right assets at the right times.
Dispersion refers to the spread of returns among different securities within a particular market or index. Higher dispersion means a wider range of returns. For active managers, high dispersion presents an opportunity to beat the market by selectively picking stocks that are expected to perform better than others.
Of course, both market timing and stock selection involve risk. An active fund manager has the potential to outperform if they get it right, at the risk of underperforming if they get it wrong.
Theory versus practice
Vanguard analyzed the performance of active U.S. equity funds during periods characterized by volatility and dispersion over a 24-year period, from the start of January 2000 to the end of December 2023.
As you can see from the table below, there doesn’t seem to be a particular relationship between average excess return and either volatility or dispersion of returns. In fact, active managers performed worst of all in periods when volatility and dispersion were at their highest. In aggregate, they produced a negative return of 44 basis points a month during those periods, which equates to more than a whopping 5% a year.
To put it another way, active managers delivered their lowest returns when the opportunities for outperformance were greatest.
The research team at Morningstar
recently conducted a similar analysis of their own. Specifically, Morningstar looked for signs that active managers fare any better than usual when dispersion is high.
To measure dispersion, they calculated the interquartile range (that is, the gap between the 25th percentile and the 75th percentile) of calendar-year returns for stocks included in the S&P 500 index. The bigger the interquartile range, the higher the dispersion of returns, and, in theory, the greater the potential for skillful active managers to outperform. Dispersion was highest during periods of market turmoil, such as the dotcom crisis, the global financial crisis and the downturn caused by the COVID-19 pandemic in 2020.
Morningstar did find a positive relationship between return dispersion and the success rate of actively managed funds. However, the percentage of funds that beat their benchmarks was below 50% in 21 of the past 25 calendar years. On average, only about 37% of these funds came out ahead of the index in a typical calendar year.
The other real problem investors face, according to Amy Arnott, a strategist with Morningstar Research Services, is that it’s difficult to identify, ahead of time, fund managers who are likely to outperform consistently.
What “a stockpicker’s market” really means
“Being in a stock-picker’s market is one thing,” says Arnott, “but consistently taking advantage of it is challenging. When you hear ‘it’s a stockpicker’s market’, what that really means is, ‘Here’s why you should pay more for an active manager’. And the odds that paying up will lead to better returns are low — no matter what the market environment.”
In short, talk of stock pickers’ markets and times for active management is really nothing more than fund industry marketing. It’s designed to get you to pay higher fees when you really don’t need to.
The bottom line is, active investing is a risk. Active managers inevitably make some good calls, but they’re bound to make some bad ones too. So although it might pay off in short bursts to pay for active management, you’re almost certainly better off investing in low-cost index funds in the long run.