Gallery:Step 3|Stock Pickers Graveyard

The Dying Business of Picking Stocks – From the Wall Street Journal

Gallery:Step 3|Stock Pickers Graveyard

The Wall Street Journal recently published a series of articles under the title “The Passivists.” Highlighting the merits of a passive investment approach, authors tackle topics such as the fruitless endeavor of trying to pick winning stocks to the “Do Nothing All Day” investment approach taken by Nevada’s $35 Billion pension fund. For each article we provide a synopsis as well as our own commentary to build upon the great work highlighted in this series.

Authors Anne Tergesen and Jason Zweig discuss how the indexing revolution has transformed the mutual fund industry, corporate boardrooms, and Wall Street itself. Citing data from Morningstar, $1.3 Trillion has flowed to passive mutual funds and ETFs over the 3-year period ending August 31, 2016, while their active counterparts have lost 25% of their total assets under management over the same time period.

The verdict is in: Index funds are here to stay.

The benefits of passive investing include superior performance over time, lower fees, and a straightforward investment approach that doesn’t leave most investors scratching their heads in terms of understanding what exactly they are invested in.

Speaking of investment strategies that will leave you scratching your head, hedge fund managers have been shoring up assets as they attempt to justify their ridiculous fees and, for the most part, inferior performance. In other words, the “Wizards of Wall Street” have been exposed.

The trend has been strong over the last decade. According to data from Morningstar, 66% of all mutual-fund assets are still actively managed, but this is down from the 84% we saw just one decade ago. Why is this the case? Simply put, performance!

For the 10 years ending June 30, 2016, between 71% and 93% of active U.S. stock mutual funds (depending on type) have either closed or underperformed their respective indexes, according to Morningstar.

As Cohen & Steers, Inc. acknowledged in their March shareholder letter, “at some point, every industry faces a defining moment—a reckoning that fundamentally alters the market landscape. It’s a way of purging stale business models to make room for the next generation. Those who anticipate and position themselves in the sea change have a chance to survive and even thrive. Those who don’t are relegated to the dustbin of history alongside Eastman Kodak and Blockbuster. That moment has arrived.”

Passive investing has also invaded the institutional money management space. According to consulting firm, Callan Associates, Inc., employer-sponsored retirement plans have 25% of their assets in index funds, up 19% from 2012. Similarly, Greenwich Associates reports that U.S. stocks allocations in index funds are up to 60% at the end of 2015 versus 38% just three years prior. Endowments and foundations also saw their share of index fund assets grow to 63% from 40% over the same time period.

There are also the legal motivations for moving to a passive investment strategy for institutions. The unreasonably high fees often associated with active investment strategies coupled with the long-term underperformance have many investors questioning whether there is a breach of fiduciary duty taking place before their very own eyes. Public pensions, like the Illinois State Board of Investment, are one of the many who have decided to go “all index” when it comes to their investment lineup given the “pretty high burden of proof” the accompanies justifying an active investment approach.

Chief Investment Officer of the San Diego Employees Retirement Association, Stephen Sexauer, sums it up quite well, “you have to ask yourself, ‘If we’re spending all this money on fees, where’s the evidence of success?’ And it’s really hard to find.”

We at IFA have in fact looked under the hood of many of the well-known actively managed investment firms to see how their performance looks compared to their respective benchmarks across their entire firm. What we find most of the time is substantial sub-par performance while charging 6 to seven 7 times more than a simple index fund, on average. You can find a list of these analyses here: Wells FargoMFS Investment ManagementJP MorganLord AbbottUSAAMidas FundsThriventAmerican FundsFidelity Part 1Fidelity Part 2Oppenheimer FundsT. Rowe PriceInvesco, Vanguard, BNY Mellon, and Dreyfus.

Chief Investment Officer of the Oregon State Treasury, John D. Skjervem, also acknowledges the current trend as being permanent, “what’s going on is a generational shift. Guys like me are moving in, and we had an education that was empirically more rigorous than the prior generation’s.”

Mr. Skjervem has an MBA from the well-known University of Chicago, the epicenter of empirical research into the behavior of markets, particularly the capital markets. The University of Chicago is home to finance heavyweights like Merton Miller and Eugene Fama, whose research led to the birth of index funds in the 1970s.

Known for taking a serious empirical inquisition into understanding the capital markets, the University of Chicago has transformed the way we understand how markets work. With the establishment of the Center for Research in Security Prices (CRSP), researchers had finally found the most complete historical dataset of both stock and bond prices as well as historical mutual fund performance. Thousands of research papers have been published thanks to CRSP. As Mr. Skjervem reflects on his own experience, “when you adopt an empirical framework, you expose a lot of storytellers. I’m very uncomfortable in the realm of narrative. I want to listen to the data instead.”

With the newly published “fiduciary rule” by the Department of Labor scheduled to go into effect next April, there is an expectation that we will continue to see the overall shift to passive investments as advisor and brokers alike will have to demonstrate that their recommendations are in the best interest of their clients. Through this vein, active managed doesn’t have a leg to stand on.

You can find the original article published in the Wall Street Journal here.