Prepare for Turn: Macro/Passive Out and Selective/Active In

Monday, October 18, 2010

Macro investing is losing its grip on investment returns as “global” twists and turns (and frights) diminish in importance. In its place is a growing realization that security selection is back – that there is good money to be made by correctly separating the winners from the pack.

Therefore, expect macro investing to give way to selective investing. Here’s why and what we can do to take advantage of the shift…

Macro investing has a natural appeal. It seems easier (and safer) to sit above the fray and make total market moves like “sell US stocks” and “buy emerging market bonds.” It’s almost fun, especially in an election year, to focus on what the government (e.g., Congress, the Federal Reserve and the SEC) is up to. And it seems sophisticated to make global pronouncements like “emerging market debt is looking good” and “Ireland’s credit rating could decline, hampering Europe’s attempt to… (fill in the blank).”

However, macro investing is born out of unusual times, when global-type forces have an outsized effect on returns and volatility. Although its life can be self-perpetuating for a while (as popularity swells), it is soon replaced when individual security analysis once again takes over.

This is when differentiation can pay off – i.e., when picking specific investments can produce bigger returns and/or less risk. Already, we are seeing this dynamic at work. As always, when the return comparisons become more evident and widely known, investors will move. Here are some recent developments:

  • In spite of Pensions & Investment Age October 12 headline “September hedge fund returns best in more than a year,” hedge fund indexes were up 3.5% and less. At the same time, September stock returns shone (MSCI World index = 9.6% and S&P 500 index = 8.9%). Bonds exhibited their low yield-based returns (Barclays Aggregate = 0.1%).
  • Active management outperformed, with many actively managed US stock mutual funds beating the S&P 500 Stock Index (e.g., about 80% of Fidelity’s actively managed funds had higher returns).
  • Some recognized individual stocks are outperforming and drawing investors’ attention – e.g., Apple (AAPL) was up 16.7%.
  • At the same time, the effect of growing merger and acquisition (M&A) activity is heating up stock picking interest. For example, “Return of the LBO [leveraged buyout opportunity]” (Barron’s, by Andrew Bary, October 18, page 19): “Cash-rich private-equity firms are on the prowl for buyout candidates, and Wall Street has drawn up lists. So have we. Here’s our view of the a dozen likely targets.” From the same issue, “Racing to the Bargain Basement” (Barron’s, by Leslie P. Norton, October 18, page 21): “Move over, growth stocks. As companies bid up the shares of low-priced acquisition targets, value stocks as a group should get a nice lift. Here’s how to get in on the action.”

How to be ready for this trend shift

I believe the following steps can help us take advantage of a shift from macro to selective investing:

  1. Reduce or eliminate macro-based funds and holdings
  2. Reduce or eliminate index (AKA “passively managed”) funds
  3. Invest in actively managed funds and portfolios
  4. If you are comfortable doing so, invest in some individual securities you select

Note A: Steps 1 and 2 mean most hedge funds, exchange traded funds (ETFs) and index funds could be sold. While they are favorably viewed now, that does not mean they will produce good, future returns. In investing, popularity today often means disappointment tomorrow.

Note B: Step 3 can worry some investors because they have heard that over one-half of actively managed funds underperform passively managed (index) funds over time. That’s true, but not proof they should be avoided. As in any endeavor, some practitioners are poor, some are average and some are good. Skill is not random, and well-managed funds can be identified. Importantly, good active managers can produce higher returns and better risk control. My career was built seeking out and selecting superior investment managers – it can be done.

Note C: Step 4 is a suggestion because I strongly believe there is valuable experience from picking and owning a few securities. The understanding gained can lead to better investment practices in the future, including working with a hired professional.

So… Now is an excellent time to prepare for the likely trend shift at hand. Making the moves now could produce better returns and risk control.

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