Why 2017 could be the year stock pickers regain their edge

Stock picking may be back, for real.

The Federal Reserve is finally moving further away from easy monetary policy and is on track to raise interest rates two or three times this year. Inflation is rising, the U.S. economy is improving, and potential tax reform and infrastructure spending under the Trump administration could add to that growth.

And those economic themes indicate to many active managers that 2017 may be the year the art of selecting stocks can bring better returns.

"I do think we might be at a very critical turning point for investors," said Ronald Temple, managing director and co-head of multi-asset at Lazard Asset Management.

"For the last eight years I've been worried about the risk of deflation," he said. Now as inflation is on the rise, "transitions like this can be great opportunities for active managers to deliver" returns better than the market at large.

Already this year, five of the S&P 500 sectors are negative, while the top performer, materials, is up 5 percent.

The active fund management business has struggled over the last several years as their investment strategies didn't perform better than the broader market, while the rise of lower-cost exchange-traded funds (ETFs) became more attractive for many investors. Last year, just 19 percent of large-cap active funds had better performance than their benchmark index, down from 41 percent the prior year, Bank of America Merrill Lynch said in a report earlier this month.

"With the central banks basically propping up the market and everyone turning into a macro investor, everyone became a passive investor because everything was so correlated," said Bernie Williams, chief investment officer, investment solutions, at USAA.

Now with rates rising, Trump's election and promises of pro-growth policies, "I think you've started to see value outperform and active managers do better," Williams said. Value stocks generally include those tied to economic cycles, such as automakers or homebuilders.

Analysts at the Wells Fargo Investment Institute said Monday that rising rates could help the struggling hedge fund industry, which is supposed to be in the business of picking stock winners but has languished for about six years.

Beating the market was especially a challenge as sectors increasingly traded in sync, or with what professional investors call high correlation. The closer a correlation is to "one," the more likely that moves in one sector result match moves in another sector or sectors, so it matters less where money is parked.

Now, those linkages among different stock sectors and asset classes have fallen to multiyear lows. Analysis from Morgan Stanley released last Friday showed that correlations between stocks and rates have reached lows not seen since 2013, and before that, in 2006 to 2007. Within equity indexes, correlations are down near levels seen only a few times in the last decade, the report showed.

While every year seems to produce experts who proclaim that stock picking is making a comeback, "the data seems to be supportive of it for once," said Eddie Perkin, chief equity investment officer at Eaton Vance.

"There will no doubt be ebbs and flows in correlations over the year and beyond," he said, "but as long as the Fed is biased towards tightening it should be biased towards differentiations at the individual stock level."

Investment firms are already working to try to take advantage of the low correlations.

In BlackRock's outlook for 2017 released in mid-December, the investment firm said fiscal and regulatory changes should benefit some sectors more than others, while historical relationships between U.S. stocks and investments like commodities were breaking down.

"The support of monetary policy is no longer there," said Terry Simpson, director and multi-asset investment strategist for BlackRock's Global Investment Strategy team, a division of the BlackRock Investment Institute.

"As this happens, this could create opportunities for active managers," he said. "There's going to be new winners in this part of the cycle."

Analysts said world markets, much like those in the United States, should also trade less in sync. Other countries' central banks remain on a more stimulative path of monetary policy, while a wave of protectionism could tighten national borders and accentuate differences among national economies.

"You could see more significant dispersion of returns, lower correlations among countries," Perkin said.

That said, just because stock picking may be recovering its validity as an investment strategy, that certainly does not guarantee that active managers will make money.

Chris Johnson, head of U.S. ETF distribution at RBC Capital Markets, said investors may still choose passive investments, as some types of ETFs, such as factor-based ones, did not exist in previous periods of low correlations.

"It is highly likely ETFs will continue to take assets away from traditional, actively managed mutual funds," he said, "in spite of the perceived market opportunities inherent in this lower correlation environment."