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After years of faltering, stock pickers see signs of hope

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They're some of the most-shunned people in investing, and if there were ever a time for them to make a last stand, it's now.

After watching hundreds of billions of dollars head out the door, stock-picking managers of mutual funds say conditions are starting to turn in their favour, and they're in the best position in years to finally beat index funds. A lot is riding on whether they do. Predictions for the death of stock picking aren't slowing, and they're coming closer to truth with each dollar saying goodbye to the industry.

"The revenge of active management" is one of the themes that strategists at Jefferies see for 2017, for example. Even so, they say that a good year for stock pickers wouldn't be enough to reverse the tide underway from actively managed funds into their index-fund rivals. It would likely just slow the movement.

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The migration has been happening for years for simple reasons: Index funds have performed better than ones run by stock pickers, and they have lower fees. For the average actively managed fund, $84 of every $10,000 invested went to cover costs in 2015, according to the Investment Company Institute. Index funds charge less because they merely try to track the S&P 500 and other indexes, rather than beat them. Average expenses for stock index funds were $11 of every $10,000 invested.

That head start means actively managed funds need to perform better than the index just to match its performance. And only a select few have done so recently.

Just 15 per cent of actively managed large-cap stock funds beat the S&P 500 over the 10 years through June 2016, according to S&P Dow Jones Indices. The last year the majority of actively managed large-cap stock funds beat the S&P 500 was 2007.

The difference in performance means investors favoured index funds by a record margin last year, according to Morningstar. They pumped nearly $505-billion into index funds, while withdrawing $340-billion from their actively managed rivals.

Active managers see cause for optimism. Among the reasons they say the table is no longer tilted so much against them:

  • A more diverse market.

For years, stocks often moved in unison. During the financial crisis, nearly everything crashed on the threat that the global economy may collapse. In ensuing years, stocks rose en masse after stimulus from central banks around the world helped to provide a rising tide.

It's a concept called correlation, and when it's high, stocks are moving together in herds, and stock pickers have less of a chance to differentiate themselves from the index. There's less of a reward for avoiding losers or identifying winners if everything's behaving the same way.

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Now that that the Federal Reserve has ended its bond-buying stimulus program and begun to slowly raise interest rates, analysts expect stocks to move more independently. The Fed raised rates in December for just the second time in a decade, and more increases are expected in 2017.

Instead of focusing on the effects of the Fed's stimulus, markets will pay more attention to how individual companies are performing, the thinking goes. Average stock correlations are now close to their lowest level in years, according to Goldman Sachs strategists.

That has stock pickers optimistic that they'll be able to separate out winners from losers, and that they'll once again get rewarded for it.

  • A more volatile market.

President Donald Trump came into office promising to shake things up, and market watchers expect that to result in bigger swings for stocks. Big changes in policy may be coming, from how much businesses pay in taxes to how connected the U.S. economy remains with the rest of the world's, and the heightened uncertainty could make things bumpy.

While that can be a scary thing for investors focusing on their 401(k) accounts, stock-picking fund managers often welcome higher volatility. When a stock they like and have been following for a while drops in price, they say it gives them the opportunity to buy low.

Regardless of whether stock pickers find 2017 more welcoming for their style than earlier years, many experts say the first focus for fund investors should remain on keeping costs low.

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Conditions may be improving for stock pickers, but just because they get more opportunities doesn't mean they'll always take advantage of them. A fund with low costs, meanwhile, will always begin with a head start over higher-cost funds. Index funds have lower costs than ones run by stock pickers, but even within actively managed funds, there can be a wide range of fees.

Studies have shown that funds with the lowest expenses tend to have the best returns, no matter how well-liked or shunned their managers are.

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