Stock Picking Is Dead!

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by: Dale Roberts

Summary

A Jason Zweig article outlines the significant flows of monies to passive ETFs compared to active management.

Advisors have the option to use smart beta funds to tailor portfolios that seek Alpha or better risk-adjusted returns.

I believe that core and smart beta ETFs will soon or eventually dominate the marketplace.

The trend is consistent and accelerating. To paraphrase a movie title - the stock picker is "Dead Man Walking". Oh! he's still alive somewhat, but he's walking to the chamber. To borrow from the land of TV series the stock picker is "The Walking Dead". Uh, pick yer favorite analogy.

With all seriousness, this is one of my favorite topics; the battle between "Active" and "Passive". The problem is the lines are blurring between what is active and what is passive investing. As an investor, I sit in the middle with investments in balanced international index portfolios, stock 'pick' portfolios and a mix of ETFs and individual stock holding portfolios. I see and know the benefits of each approach. I also have the luxury of chatting with investors who may seem to have a mix of active funds, passive index funds and some individual stock holdings thrown in 'here and there'.

All said, the massive money move from active funds and active stock picking to Exchange-Traded Funds ((ETFs)) is pronounced and undeniable. The reason for that move, of course, is that active management does not beat even the passive plain vanilla broad market index investing. The final spike in the stock picking coffin is the advent of smart beta (active) factor based ETFs that can typically do what active investing is supposed to do. And that is, find a bunch of stocks and deliver alpha or better risk-adjusted returns compared to those plain vanilla (I like to call it meat n potatoes) investing such as the value weighted S&P 500 (NYSEARCA:SPY). So long stock picking, it was nice knowing ya.

Right off the bat, we know that historically cap weighting the S&P 500 members is a drag, a total return drag. The equal weight version (NYSEARCA:RSP) offered by Guggenheim has a history of beating the cap weighted SPY. In a recent article, I discussed the simple two ticker Perfect Portfolio of 80% RSP and 20% longer term treasuries (NYSEARCA:TLT). Here's the article. Into dividends? The check out the Perfect Portfolio: Dividend Growth Edition. It offers a low volatility core with a mid to small-cap booster.

With RSP, you take a market beating 'smart' beta approach, OK, it's not even smart, it's just a simple weighting differentiator - and then you add some bonds to outperform through a market correction. And now we're onto what is really important and what many investors and financial planners will continue to realize what is important and that is Portfolio Design. Of course, that portfolio has to be created to match the goals of each individual investor, and that portfolio has to align with the risk tolerance level of each investor. Investors and advisors can then spend more time on what works - portfolio construction and KYC (Know Your Client) and less on what does not work - guessing what companies to buy (active management).

Jason Zweig, blogger and writer for the Wall Street Journal, contributor to The Intelligent Investor Editions, wrote an article in 2016 on the death of stock picking. In that article, The Dying Business of Picking Stocks he detailed how...

Over the three years ended Aug. 31, investors added nearly $1.3 trillion to passive mutual funds and their brethren-passive exchange-traded funds - while draining more than a quarter trillion from active funds, according to Morningstar Inc.

It's not over yet, but, from that same article ...

Although 66% of mutual-fund and exchange-traded-fund assets are still actively invested, Morningstar says, those numbers are down from 84% 10 years ago and are shrinking fast.

Performance is driving the upheaval. Over the decade ended June 30, between 71% and 93% of active U.S. stock mutual funds, depending on the type, have either closed or underperformed the index funds they are trying to beat, according to Morningstar.

The move is massive as ETF lead BlackRock (NYSE:BLK) recently reported, the trends are accelerating. From the BlackRock Q4 earnings release...

"Increasingly diversified groups of institutional and retail clients are using ETFs in their portfolios. This broadening of the ETF ecosystem is creating a deeper secondary market for ETF trading - enhancing liquidity for all investors. iShares generated a record $140 billion of net inflows for the year, including $60 billion into iShares fixed income ETFs, capturing the #1 share of flows globally, in the US and in Europe, and in equity and fixed income.

And, as we see on Seeking Alpha, many stock pickers are dabbling in ETFs to balance things out or to 'test them out'. Many, who benchmark their own returns, are now discovering that they are underperforming the 'passive' approach. While individual stock pickers or discount brokerage retail investors is not a large group, the segment will continue to pick up steam and many will embrace the ETF portfolio construction model.

One of the recent and dominant trends is the robo advisor services. The offerings typically build model portfolios by way of ETFs. The robo advisor will potentially displace the 'human' advisors. Many of the robo advisors are growing at an incredible clip. The robos are targeted to the Millennials who love to take things online and let technology do the talking. Once again, the ETF industry will be one of the main beneficiaries of this growing trend.

Now, does this mean that active management will go away? No. It can't. The market needs participants who know how to evaluate companies and how to 'price the companies'. The market will always create distortions and the expert investors will be there to take advantage of the opportunities. Indexers are freeloaders. They benefit from the market research by being able to buy at what the market (experts) think is a fair price for a company. The indexer simply does not pay those experts for the time and efforts.

I am of the school that believes or guesses that when we have a much, much smaller group of active managers required, the markets will get a bit, or a lot smarter. Darwin will raise his hand and the weak and lazy and less-talented active managers will be looking for other work. The most talented and skilled active managers will remain, meaning the markets will get smarter and perhaps more efficient. Throw in the smart beta ETFs that may pick up enough assets to help price the markets and we may have a one-two punch leading to smarter markets. Can markets be absolutely efficient? Well, no, efficient markets is an oxymoron. Even CEOs don't know what their earnings will be next year or five years out. But perhaps markets can get a little bit 'smarter'. We'll save more on that for another day and another article.

I also believe that the new trends - proper portfolio construction with risk management at the core will lead to better investor behavior and less volatile markets. Are we seeing evidence of that today? We know human advisors have done a terrible job at preparing investors to be able to navigate through market corrections. It's the turn of the robos and other simple portfolio modeling tools that match the appropriate portfolio to investors' goals and risk tolerance levels. And yes, many of the human advisors will get in line. It ain't Rocket Surgery.

Ha, so many interesting subjects to think about, and write about.

Thanks for reading, I appreciate your comments and insights. And, of course, always know and invest within your risk tolerance level.

Disclosure: I am/we are long BCE, TU, TRP, ENB, BNS, TD, RY, AAPL, ABT, BLK, BRK.B, CL, CVS, JNJ, LOW, MDT, MMM, MSFT, NKE, PEP, QCOM, TXN, UTX, WBA, WMT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Dale Roberts is an Investment Funds Advisor at Tangerine Investment Funds Limited a subsidiary of Tangerine Bank, wholly owned by Scotia Bank; he is not licensed to provide professional advice on stocks. The opinions expressed herein are Dale Roberts' personal opinions relating to his experience as an investor and are not those of Tangerine Bank or its subsidiaries and/or affiliates. This article is for information purposes only and does not constitute investment advice or an offer or the solicitation of an offer to buy or sell any securities. Past performance is not a guarantee and may not be repeated. Investment strategies are not suitable for everyone and you should always conduct your own research or speak to a financial advisor.