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Fund Managers are Crying

Written by Briton Ryle
Posted February 25, 2015

Oh, boo-hoo. America's fund managers, who are paid some pretty hefty sums to pick stocks that will do better than others, can't beat the S&P 500 benchmark.

And they are blaming the Fed.

Sure, we can blame the Fed for some stuff, like the shale oil bubble. Low interest rates encouraged American shale oil companies to take on $550 billion in debt over the last few years, funding production increases to the point where the oil market became oversupplied. That's the very definition of a bubble...

But blaming the Fed because your stock picks suck? Wow. I bet their dogs ate their research reports, too...

Apparently a group of fund managers told Bloomberg:

[Fund] Managers say they haven’t changed, the market has. The easy money climate of near-zero interest rates engineered by the Federal Reserve has artificially inflated prices of lower-quality U.S. stocks, they say, punishing those who focus on businesses with the best fundamentals. At the same time, the relentless climb of prices across equity markets has left them with few chances to sniff out bargains or show what they can do in more-volatile times.

One fund manager even said: “In straight-up markets you don’t need active managers... If the next five years are the same, there won’t be any active managers left.” 

And maybe that's how it should be. Only one in five active managers did better than the S&P 500's 14% gain last year.

Individual investors are well aware that fund managers are having a tough time earning their management fees. Last year, they collectively pulled a net $98 billion out of actively managed funds and invested a net $167 billion into passive index funds.

"Pay No Attention to the Man Behind the Curtain"

Personally, I'm impressed at how savvy individual investors have become in regard to their investment money.

They clearly are not buying the Wall Street "black box" BS anymore. That's great. Because there really is no "black box" that guarantees the stocks in which a fund manager invests will go up.

Still, it's true that very few stocks have been able to outperform over the last few years. There are only a few companies whose strong growth is being rewarded with a higher-than-average stock price. Companies like Netflix (NASDAQ: NFLX), Amazon (NASDAQ: AMZN), and Tesla (NASDAQ: TSLA) come to mind...

Here's an example I use often: There is simply no reason Apple (NASDAQ: AAPL) should be cheaper than Johnson & Johnson (NYSE: JNJ), but it is. Apple's forward P/E is 14.5, while JNJ is trading at 15.5 times its forward earnings estimates.

And if you look at the price-to-earnings growth (PEG) ratio, the difference is glaring. Apple trades at 1.2 times its earnings growth, while JNJ trades at 2.7% times earnings growth. In terms of growth, JNJ is the more expensive stock.

Now, of course you could argue that Johnson & Johnson has a long history of stable revenue/earnings growth and dividend payments, while Apple has only been awesome for 10 years and the cell phone/tech gadget market is notoriously fickle. So maybe JNJ deserves a safety premium in its share price.

Safety in Big Cash Numbers

But the "safety" argument doesn't really hold up.

JNJ will pay out a little over $5 billion in dividends this year. And in July, the company announced a $5 billion share buyback. Assuming that buyback is half done, JNJ will return ~$7.5 billion to shareholders this year.

Apple? The dividend will be $10 billion and the share buyback announced in October 2014 was $17 billion.

In other words, Apple will return three times as much money to shareholders as JNJ...

And then there's Apple's incredible $178 billion in cash. JNJ's total market cap is $280 billion. Apple has two-thirds of that — in cash. Whether you like iPhones are not, it's pretty hard to call Apple risky...

So why is Apple so cheap? I think it's partly because of indexing. When you buy an index fund, the money is spread among the stocks of the index according to how each stock is weighted, or represented in the index.

In other words, each stock will go up by the same amount. They move in lockstep. With more money going into index funds than actively managed funds, it becomes harder for individual stocks to buck the trend and outperform.

I also think the Fed's low interest rate policy has pushed investors seeking income yield into dividend-paying stocks, which has helped push those valuations higher to the point that they are comparable to, and sometimes higher than, growth stocks. (My Wealth Advisory subscribers have enjoyed excellent gains on our dividend stocks because of this, especially REITs.)

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If You Can't Beat 'Em...

Of course, there is another issue that these fund managers may be missing: If what you're doing isn't working, maybe you should try something different...

The fact is, the market changes. What's hot one year goes cold the next. The winners of one cycle can often be the losers of the next cycle. Between 2005 and 2008, Chinese stocks were hot. Not so much anymore...

Commodity stocks were hot for pretty much the entire first decade of the 2000s. But copper, iron ore, steel, coal, natural gas, and now oil have gone in the tank over the last couple of years. Two years ago, 3D printing stocks were hot. Three years ago, it was cloud stocks.

Last year, health care and utilities were the best performers. This year, it will certainly be something different again.

The whole point of "actively managed" is that you have the ability to get into the stock that will perform better... so why not try that, Mr. Whiny Fund Manager?

And besides, the idea that stock prices all move together and you can't pick winners probably isn't even true. Consider this nugget in the Bloomberg article:

In each of the last eight years, at least 70 percent of the stocks in the broad Russell 3000 Index either beat or underperformed that benchmark by 10 percentage points or more...

Vanguard's Jim Rowley supplied that data, which clearly shows that individual stocks do indeed have the power to buck the trend and move more than other stocks or the underlying index.

Rowley told Bloomberg: “That would suggest there has been ample opportunity to pick winners and losers.”

Join 'Em

Of course, this too shall pass. When everybody hates stocks again, the ability to find the nuggets in the scrap heap will become valuable again. 

And for the record, my last few recommendations for my newsletter The Wealth Advisory are up 13.4%, 14.6%, 12%, and 6%.

Not bad, but if those gains aren't beating the S&P 500 right now, I won't be crying about it.

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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