A Task Destined to Fail
A Janus PowerPoint landed in my email--a presentation as to why investors should buy Janus actively managed stock funds.
Presentations about the virtues of actively managed stock funds are inevitably painful. (The lone exception is American Funds' recent defense, which dispensed with the general defense of active management and emphasized instead that which is true, the exception of American Funds' stock funds.)
I opened the presentation, which seems to have been produced in early 2013, with the anticipation that Pride and Prejudice's Mr. Bennet feels when visited by his cousin Mr. Collins. He does not know what follies will come, but come they will, and he will delight in their variety.
1. Exchanged-traded funds (ETFs) are growing.
A promising start! We are told that all ETFs are index funds (hmmm, I think PIMCO Total Return ETF begs to differ), and that ETFs struggle to keep up with a "rapidly changing global business climate" because their indexing approach "continuously chases market capitalization." ETFs "look backward, not forward."
Folly Score: High. Strong marks for recycling a 40-year-old argument in 2013. Bonus points for conflating ETFs with indexing, for implying that market-capitalization-based indexes must trade to "chase" their benchmarks, and for using the clichéd criticism that another investment manager "looks backward." Everybody looks backward; try foreseeing the future otherwise.
2. Stock correlations are declining.
The trailing one-year correlation among the market's largest 50 stocks was relatively low by recent standards in January 2013, sharply down from year-earlier levels. This is good news for active management because "the rest of the market" is beginning to "recognize the company-specific issues the active manager has been looking at all along."
Folly Score: Medium. I'm not certain about the thesis. The category rankings for Vanguard Total Stock Market Index (VTSMX) in 2011, 2012, and 2013 year-to-date are nearly identical. In each year, the index fund beat about 70% of its actively managed competitors. Per Janus' theory, that fund should have fared worse in 2012 than it did in 2011. I would need to do more research to comment further, but I am suspicious.
Even if Janus' claim is correct, however, there's little sense in making active/passive decisions based on stock correlations, since such patterns are quite unstable. Low now might become high tomorrow.
3. Companies have a lot of cash.
An odd point.
Per Janus, companies have record amounts of cash, which they will use to repurchase shares, raise dividends, or make strategic acquisitions. Index funds can't use knowledge to determine which companies are making prudent decisions with their cash, and which are not.
Folly Score: High. A knuckleball, early in the presentation--if this is the third slide, what is to follow? Really, this point is nuts. It only works if active investors somehow are better at evaluating company cash decisions than they are at evaluating everything else that companies do, and if the cash decision as executed in 2013 is very important to stock prices.
4. It's time to buy aggressive stocks.
Janus notes that through December 2012, three-year total returns for the defensive sectors of health care, consumer staples, and utilities outstripped the gain of the S&P 500. In addition, investors have been heavy buyers of dividend-paying stocks in recent years. Passive funds can do nothing except follow along. Active funds, on the other hand, can overweight the more-aggressive, higher-beta stock sectors that have been somewhat ignored.
Folly score: Low. Once again, there's the implication that active managers as a group can successfully predict the future. There's also the chutzpah in writing that after a four-year surge in stock prices, at a time of high stock-price multiples and possible Federal Reserve tightening, investors should assume more risk. But ... Janus was mostly correct. Stocks have behaved largely as it wrote.
5. Investors are no longer afraid.
When investors are worried, they "focus only on the immediate event in front of them." When they are more confident, on the other hand, they "refocus on a company's longer-term outlook" and that is when active managers "can be rewarded."
Folly Score: Medium. Top marks for the premise. Active managers know what will happen five years out, but they cannot outperform either indexes or amateur investors in determining nearer-term events? Aren't active managers supposed to be the ones who have all the data that help them keep their fingers on the pulse of businesses? Doesn't Janus boast of its research staff staying abreast of company developments?
Also, I don't see evidence that managers do better at times of investor confidence. During the optimism of the New Era, the S&P 500 was a famously difficult benchmark to beat. In the deep gloom of 2009, on the other hand, the Vanguard 500 Index (VFINX) suffered its worst relative performance in years.
The prediction was once again correct, though. Fear has indeed subsided.
6. Stocks are cheap.
Entering 2013, stated Janus, "valuations for equities" were "below historical averages" and were "particularly attractive." Low interest rates will drive asset flows into equities, thereby pushing up stock prices. This will help active management because active managers "can seek out the stocks they believe are mispriced."
Folly Score: Medium. The premise is silly. A rising tide that floats all boats [note: I wrote this sentence before reading Janus' claim No. 8] is good for active management? How so? Apparently, when correlations are low, active managers benefit, and when correlations are high, active managers benefit. Funny how that works. However, Janus was right in its expectation of rising equity-fund flows and stock prices.
7. Mergers and acquisitions will increase.
This is the same logic as claim No. 3. A business activity will increase, active managers evaluate this activity, thus active managers are poised to benefit. In this instance, the activity is corporate actions, which Janus figured would increase in 2013.
Folly Score: High. Yet another knuckleball, another failure to explain why investment managers as a group are particularly skilled at evaluating this particular activity, and another failure to explain why this activity is so important for stock prices. In addition, this time Janus muffed its prediction. Merger-and-acquisition activity slowed in the first half of 2013.
8. The economy will grow slowly, not quickly.
Strong economic growth can buoy weaker companies, but when economic growth is slow, then only the good ones thrive--the companies that active managers are able to identify. "Without a strong rising tide, it may help to have an active manager pick the most buoyant boats." Apparently, if the tide consists of cash flows into equities, then a powerful tide is good for active managers, but if the tide is economic, then a weak tide is good for active managers.
Folly Score: Medium High. The idea very likely can't be supported by the long-term data, and it has been off track recently. If low economic growth helps active managers, then they should have fared well since the middle 2000s. Give Janus modest credit because GDP growth has indeed been slow. But that was an easy call.
9. Among active managers, the most active ones fare the best.
Per research by Antti Petajisto of NYU (and elsewhere by Martin Cremers), the more a U.S. stock fund differentiates itself from an index, the stronger its relative performance. Better that an active manager be bold than be a "closet indexer" who owns many of the same stocks as a market index. The most active of managers, in fact, beat their benchmarks even after expenses.
Folly Score: Medium Low. This is not an argument for active management as a whole, but rather for a subset of active managers. Also, Janus does not demonstrate that it belongs in that subset. The basis is, however, a well-respected study from an outside academic source.
10. Don't settle for being average.
"Don't be tempted by the recent returns of passive funds. Passive funds did, in fact, outperform most active funds over the past few years [so much for the slow-growth theory], but the market environment during that time was atypical....Over longer time horizons and normal market cycles, passive equity investing has meant settling for middling performance at best."
Folly Score: 11. Did we enter the Hot Tub Time Machine? In truth, such an argument was dated even by the 1980s. This is a disco-era claim.
I've had a bit of fun with Janus, but in fairness, this presentation is neither different nor worse than the typical defense of actively managed stock funds. The general case--that is, of the species overall, rather than of the subset of experienced, successful managers--is a difficult case to make, and fund marketing groups are unlikely to be up for the task. They would be best off forgoing the effort and letting their managers' numbers do the talking. Even in these times of index-fund popularity, assets can and do flow to leading active stock funds.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
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