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When Professional Stock Pickers Beat the Algorithms

largelast year The plunging market did little to make investors smile. Stocks and bonds both fell; safe-haven assets failed to provide a safe haven. Doing it well means losing single digit percentages instead of double. So it may seem odd for fund managers to be taking brisk steps now.

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But on Jan. 23, Citadel, the secretive Miami-based investment firm, generated $16 billion in net profits for its clients in 2022, breaking the record for the largest annual gain in dollar terms.Its lead hedge fund returned 38% — while Master of ScienceThe broadest index of global stocks fell 18%. Champagne corks have popped elsewhere, too.Brokerage and research firm Strategas Securities estimates that 62% of active fund managers investing in large U.S. companies exceed Second&p 500 index of such stocks in 2022, the highest percentage since 2005.

Thus, last year ended a miserable losing streak for stock pickers.Each year from 2010 to 2021, more than half of active managers compared their performance to Second&p The 500 couldn’t beat it. In other words, the average fund manager is at a disadvantage by a simple algorithm that blindly buys every stock in the index. Such algorithms, known as “passive” or “index” funds, are taking over. By 2021, they hold 43% of assets managed by U.S. investment firms and have a larger market share of national equities than their actively managed peers.

The logic that drives passive funds is inescapable. By definition, the performance of an index is the average performance of those who own the underlying stock. Beating the index is a zero-sum game. If one investor does this, the other is bound to fail. Aggressive managers may discover a superstar stock and eventually leave the others behind. But it also shows up in indices, so passive investors buy it too. At the same time, fees charged by active managers tend to be orders of magnitude higher than passive managers: typically 1-2% per annum, while hedge funds charge even more, compared with 0.03% for algorithmic peers. This drag on performance makes it almost inevitable that index funds will outperform human fund managers in the long run.

So how are fund managers outperforming the market in 2022? One possibility is pure luck. Pick a random group of stocks from an index, subtract a percentage point or two in fees from their returns, and occasionally you’ll pick stocks that outperform enough to outperform the average.

A variation on this allows for some finesse from the stock picker. Alphabet, Amazon, Apple, Microsoft, and Tesla account for nearly a quarter of the total global market capitalization in early 2022 Second&p 500. Their collective value fell 38% in a year; the rest of the index fell only 15%. The index is so concentrated that a single correct call — that U.S. tech giants are in a bubble and should be avoided — leaves stock pickers with a good chance to beat the market.

Extending this technical issue to broader concerns about stock valuations gives stock pickers a second chance at outperforming. In the era of cheap money following the global financial crisis of 2007-09 and covid-19, arguing about such things is outdated. Shares soar to staggering multiples of the underlying company’s earnings or assets, and continue to climb. Those who see this as avoiding them, expecting a correction lose out. Passive funds that bought everything indiscriminately, including stocks that seemed overpriced, prospered. But in 2022, rising interest rates bring that trend to a screeching halt. Investors looking for stocks that are cheap relative to their fundamentals are finally being rewarded.

For a company like Citadel, the last chance to prove its worth comes from a plunge in stock and bond prices. Market crashes and an uncertain economic backdrop are the raison d’être of hedge funds, which have the right to invest in any asset class they wish. A stock market index down by double digits is much easier if you’re not obligated to buy stocks, as are funds that track the market. For the most nimble managers, last year’s crisis looked like an opportunity. As volatile sovereign debt markets forced a sell-off in September by British pension funds, private investment firm Apollo began snapping up assets for a quick profit. Index funds are not going away, nor should they. But only occasionally, active managers get their money’s worth.

Learn more from our financial markets columnist Buttonwood:
The $300 Billion Problem with Venture Capital (January 18)
The dollar may surprise investors (January 12)
Are investors in for another bad year in 2023? (January 5)

For more expert analysis of breaking economic, financial and market news, sign up for Money Talks, our subscriber-only weekly newsletter.

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