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It has been a tough year for active managers competing with the S&P 500 since the the U.S. stock index is on track for a gain of more than 30% for 2013. Investors who bought and held index funds are feeling pretty good about themselves.
The search for alpha—the excess return on a risk-adjusted basis relative to the return of the benchmark index—is sometimes dismissed as a fool’s errand. After all, there’s plenty of data backing up the claim that passively managed index funds and ETFs usually perform better than actively managed ones.
In some cases, portfolio managers, though savvy investors, are afraid to think outside the box for fear if they make a mistake their careers will take a big hit. As Julie Segal at Institutional Investor reports, a study performed by State Street Corp.’s Center for Applied Research found that among 200 investors interviewed that career risk is the largest determinant in their decision-making process. It’s just not easy to be a contrarian investor, and the temptation to follow the herd is strong. That’s one reason why it’s hard for investors to find managers who provide consistent alpha.
Managers who run with the pack and deviate little from the index have a very slim chance of outperforming. In fact, the stocks with the lowest Wall Street analyst ratings outperformed the favorite stocks and the overall market in 2013. As Brett Arends writes for MarketWatch:
This not mere happenstance. Indeed it often works out like this. There are very simple reasons for it, and they reveal a great deal about Wall Street … The most popular stocks on Wall Street are frequently overpriced, because everybody likes them. The least popular stocks are frequently underpriced, for the opposite reason … And if you are trying to keep your job on Wall Street, the most sensible strategy is to stick with the herd and avoid needless risks.
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The surge in the popularity of index investing is being driven by investors’ frustration with paying higher fees to active managers who can’t beat the benchmark.
At Covestor, our basic investing philosophy has nothing against passively managed index funds and ETFs. We think they are great, low-cost vehicles for the “core” of a portfolio. Yet we also believe that adding up-and-coming, active managers to the mix can help investors generate alpha. The key is finding the right manager, who may not necessarily work at a high-profile Wall Street firm.
As Covestor Chief Investment Officer Sanjoy Ghosh explains:
We believe it makes sense to consider emerging managers with fewer assets under management than the big funds. Why? Because when the size of assets that an active manager oversees increases, his or her opportunities grow more limited due to liquidity constraints. The manager becomes less nimble as assets grow larger.
The bottom line is the search for alpha isn’t some mission impossible. It does take analytical rigor and a portfolio manager willing to follow the conviction of his or her ideas.
Photo Credit: SalFalko
Disclaimer: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk and various investment strategies will not always be profitable. Past performance does not guarantee future results.
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Covestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures.