In November 2021 Morgan Stanley announced that 2022 is going to be a year of stock-picking. Should we sell all index ETFs in the portfolio and rush into buying Apple at the next dip?
Let’s try to explore the upcoming threats and opportunities on the market and figure out the strategy for our portfolio. For the sake of understanding we will use two terms: active and passive investment. Active investing is picking individual stocks and timing the market, whereas passive is buying index ETFs and keeping them.
Take a guess:
In which market do passive funds outperform active funds?
The correct answer used to be bull. That’s when passive funds grow the most. The era of low rates and quantitative easing that led to one of the longest bull cycles in history is one of the reasons for such a significant influx of money in passive funds.
The question is ‘Is the bull market over?’ So that we transfer money to active funds or start selecting stocks ourselves. Well, Bloomberg warns that now, when the yield curve is narrowing, oil is jumping due to sanctions on Russia and stocks faced the biggest decline since the pandemic, ‘the argument gets stronger that it’s time to take the threat [of recession] seriously.’
Projections for 2022 are already pessimistic or at least not all bullish. This week, Goldman Sachs (GS) lowered its year-end S&P 500 index forecast from 4,900 to 4,700 points. Similarly, BNP Paribas lowered their target, writes Bloomberg. In such an uncertain situation, alpha — the ability to show returns above the market through a competent choice of assets — is becoming an increasingly important strategy, the report by Goldman Sachs says.
Looks like a job for active managers.
For decades, they have claimed that in boring markets, don’t expect them to outperform. When there are rapid changes in the economic outlook and high volatility in the markets, active managers who can make quick decisions will crush their passive competitors.
The thing is that in times of turbulence in the markets, dispersion — the difference in the returns of individual stocks from the index — increases. With it, the possibilities of managers are growing, note in MSCI. Since 1986, managers have beaten the market in seven of the nine years with the highest variance, and only once in the nine years with the smallest variance.
Therefore, active management is a preferred method of keeping high yields against the background of generally low market expectations. And stock picking has already been explicitly supported by several major managers, including JPMorgan Asset Management and Amundi Asset Management, following a review of strategies conducted by Bloomberg.
Hey, Google, how do I pick stocks during a recession?
Ray Dalio, for example, buys Procter&Gamble and sells ETFs according to reports of his hedge fund. Positions opened through exchange-traded funds are gradually decreasing: the financial sector, which includes mainly numerous ETFs, accounted for over 80% of the portfolio two years ago, now this share has decreased to 24.6%.
The Goldman Sachs report says that one should look for alpha in the fundamental indicators of companies.
BofA agrees: alpha in the US stock market should be looked for not in sectors, but primarily in free cash flow (FCF). It is this indicator that will become the king of the markets in the near future. Bank analysts believe that the economy is now in the late business cycle. It is usually characterized by rising costs and payroll costs, rising interest rates and company investment — it all boils down to FCF. Historically, in the late cycle period, companies with an attractive ratio of FCF to business value (Enterprise Value, EV) and price (Price, P) showed the best returns.
The situation gets complicated here for me as a retail investor...
Emotional and critical part
The whole part above persuaded me that markets are done with the bull part and now it’s going to be a roller coaster where I would like not to get dizzy and wasted. In order to do so, I have to switch from a passive strategy to stock picking. They even help me and tell which fundamental metrics to look at. Thanks!
But I’m being lazy and thinking about passing responsibility to an active fund which definitely has more experience and knowledge in financial markets. Here’s my general concern: if stock picking is so easy, why are active funds not outperforming all the time?
I wasn’t lazy in this part and googled the performance of active funds. Here’s what I have found.
Thesis: Active funds outperform at volatile times.
If this was true, they should’ve outperformed in 2020 and in the first half of 2021. Two recent reports by Morningstar and S&P Global come to the same conclusions: It didn’t work this time. Of the nearly 3,000 active funds Morningstar analyzed, only 47% survived and outperformed their average passive counterpart in the 12 months through June 2021.
"Roughly half beat, and half lagged. It was what you would expect from a coin flip," said Ben Johnson, director of global ETF research and the author of the Morningstar report.
FT says, the supposedly savviest investors on the planet — hedge fund managers — had a tough time justifying their fees in 2021. While the S&P climbed 27 per cent, hedge funds returned 10 per cent, according to data from Hedge Fund Research. Weighted by the size rather than the number of funds, it was 7.5 per cent.
Even the most expensive active funds won’t help. "Pricey active large-cap funds are doomed to failure: Just 4% of these funds beat their passive composite over the decade ended Dec. 31, 2021" according to Morningstar Active/Passive Barometer.
So before turning back on ETFs in your portfolio think about two things:
- Do you believe that some active fund will outperform the market given the probability of 50/50?
- Do you think that you can choose the best stocks only by doing your research when even professional managers with superior experience can’t choose all-time growing stocks?
On the bright side
They do help with pointing at some sectors that we may not have ever considered. FT Money’s investment panel conducted a meeting at the end of 2021 where finance professionals discussed investment ideas for the future. Here's what they are betting on:
- Value stocks, which have long been neglected in favor of growth stocks such as tech companies.
- Energy and mining stocks, because these sectors have seen capital investment drop in recent years amid concerns about climate change.
- Asia, where there is "very, very little inflation." In particular, railways because they manage inflation well.
- Robots, for their value in replacing workers during times of labor shortage.
Again, they will never tell which company to buy, but we can take the opportunity and buy ETF for this sector and join the advocates of passive investing, who, according to the S&P Global "tend to outperform the majority of actively managed funds, mainly over the over the mid- to long-term investment horizons".
Morgan Stanley said the strategy to go in 2022 is stock-picking. How can we, ordinary people, do it to keep up with the market? One way is to bring it to active funds managers like Morgan Stanley or Goldman Sachs. But let’s not forget who writes those analytical reports and what is the nature of their business😏
There are basically two ways: you either go along the market (aka Warren Buffet style) or you create your unique system (Adam Robison, global strategist and consultant to many hedge funds, says). In all the other ways you're going to lose. Any time you try to copy someone you fail, because it becomes a social movement and is predictable. Thus, the market can outplay you.
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