Should You Own ETFs In A "Stock Pickers Market"

Most Wall Street participants believe 2019 will be a “stock pickers” year; So how will that affect Exchange Traded Fund investors?

Well first off, what is a “Stock Pickers” market or year? That is a market in which to make a decent return; investors will need to pick individual stocks, not just buy the market as a whole or an index such as the S&P 500 or Dow Jones. At this point, most Wall Street analysts believe the major market indexes will end the higher just slightly higher. In mid-February, Goldman Sachs analyst posted a note indicating they think the S&P 500 will only climb to 3,000 by the end of the year, but the next few months could be flat.

Vanguard went a little further and said it believes the market will only return roughly 5% median annualized return over the next 10 years. Vanguard’s opinion paints an even worse picture than Goldman’s and hints at the idea that investors will need to be “stock pickers” for the next decade if they want to see returns greater than 5% annualized.

So, the experts are telling us that investors need to cherry pick individual stocks if they want to make a real-return greater than a few percent over the next year or maybe more. But what if they don’t know how to find and pick market-beating stocks, they need not worry because that is why actively managed ETFs where created.

An actively managed ETF is a fund which has a group of analysts and fund managers who pick the stocks that the ETF will own. Typically, the type of stocks the fund must hold will be specified in the fund’s prospectus. For example, if the fund’s prospectus indicates the fund will hold large-cap stocks, then the fund will not likely buy micro-cap stocks. Or if the fund is deemed a technology ETF, the fund wouldn’t likely own a gold mining company unless that mining company uses some high technology processes to extract minerals from the ground. This is in contrast to a passively managed fund such as the SPDR S&P 500 ETF Trust (SPY), an S&P 500 ETF, which just simply owns a market cap weighted percent of all the S&P 500 stocks, the actively managed funds own whatever stocks the fund managers believe will perform the best.

While we are only two months into 2019, it would already appear Goldman Sachs, and Vanguards predictions may be coming true as large-cap fundamental managers as a whole are currently beating their benchmarks by 81 basis points thus far in 2019. Furthermore, large-cap quantitative managers are beating their benchmarks by 55 basis points.

This came after 2017 when only 42% of large-cap mutual funds outperformed the S&P 500 and in 2018 when only 35% outperformed. The shift comes during a time when many analysts are also predicting gross domestic product growth rates to slow, corporate earnings and revenue growth rates as a whole to slow, all while the Federal Reserve continues to tighten monetary policies. Business investments also are beginning to slow as companies are less confident about what the future holds, and lending costs have increased.

When we begin seeing macro-economic data slowing, which is what is currently happening, think GDP and other industry-wide figures, that is a sign that on a ‘wide’ scale companies may not all perform well. Thus, this is when ‘individual stock picking is more important if you want to realize more than just a few percent return.

Year to date the top three actively managed ETF’s are the ARK Genomic Revolution ETF (ARKG) which is up 30.03% year-to-date and up 10.62% over the last month, the MFAM Small-Cap Growth ETF (MFMS) which is up 25.68% year-to-date and 13.11% over the last month, and the ARK Innovation ETF (ARKK) which is up 25.63% year-to-date and 9.75% over the last month.

Now before you run out and buy a bunch of actively managed ETFs, you do need to remember that there are a few downsides to these funds. First and foremost is they cost the investor a lot more to own. For example, the S&P 500 SPY ETF has an expense ratio of 0.09%. The three top-performing actively managed ETFs year-to-date have expense ratios of 0.75%, 0.85%, and 0.75% respectively.

Next, these funds may not always strictly stick to their funds investing theme. Often times we see internet retail-focused ETFs owning retailers who have very little if any online sales. The reason is that the fund manager believes it will be a good investment, even though it falls outside the funds investing guidelines.

Another issue with actively managed funds is that you never fully know what you own. These funds are often traded regularly, and therefore the fund's disclosures of what it owns are often outdated.

Regardless of whether it is active or passive investing you need to remember there are risks associated with investing and the market tends to turn quickly. If you are already comfortable with your passive indexed funds, perhaps you should stay with what you know. If you want a little more upside, active may be better, but remember anytime you increase your upside potential, your risk is also likely increasing.

Matt Thalman Contributor - ETFs
Follow me on Twitter @mthalman5513

Disclosure: This contributor did not hold a position in any investment at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from for their opinion.