Active management shines in a time of indexing

Passive management, or buying stocks that track an index, has caught on over the last several years. But changes in the economy and markets have made it easier for active managers to now show their worth, too. Active managers, those who pick stocks with the intent to beat an index and not just match its performance, have enjoyed a comeback in recent months and say that they’re now enjoying a more fertile ground for picking stocks.

Money managers say that there are more bargains to be had now, especially among stocks that aren’t included in the major indexes tracked by large passive funds. Last year, 63% of active small-cap growth funds and 54% of active small-cap value funds beat their benchmarks, up from 29% and 18%, respectively, in 2016, according to Morningstar.

The money that goes into passive index-tracking funds tends to gravitate toward the companies that make up an index. The result is those stocks get bid up in price because of the massive flows into passive products, while other stocks often remain cheaper.

In addition to those cheaper stocks, active managers can use stocks that aren’t typically included in a benchmark to amplify returns.

Azzad small cap growth portfolio manager Kayne Anderson Rudnick has shown how finding mispriced, unconventional securities in recent months can pay off for the strategy. The firm identified Autohome, a leading online market for Chinese automobiles. Because they liked the firm’s competitive positioning in the Chinese car market, Kayne stuck with the stock. It was the portfolio’s top contributor to growth in the first quarter of this year.

Other money managers say that when the Fed started to unwind its bond-buying program and raise interest rates, borrowing costs for businesses went up. Those higher borrowing costs mean that heavily indebted companies, the kind that were able to stay afloat when credit was easy to come by, are now lagging compared to higher-quality firms with stronger balance sheets.

With higher borrowing costs, price differences between lagging stocks and the top-performing ones have widened. This creates opportunities for active portfolio managers to find bargains.

And the proof is in the numbers. According to data from Morningstar, 53% of actively managed funds beat their benchmarks in the first four months of 2018, up from 49% last year and 29% in 2016.

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