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Stock Picking Is Back, and Hedge Funds Win

Thursday, 11 Jul 2013 | 10:57 AM ET
H-Gall | Vetta | Getty Images

Life has gotten better for stock pickers, and that could help hedge fund managers who have been languishing for years as the various sectors within financial markets have moved in lockstep.

As markets weigh whether the Federal Reserve will begin normalizing monetary policy, all active managers, beyond those just at hedge funds, have benefited from the accompanying volatility.

The second quarter saw 45 percent of the active group beat the Russell 1000 large-cap benchmark index—hardly a resounding triumph, but a marked improvement over recent performance.

"As things begin to normalize a bit, correlations not only among asset classes but also among stocks and sectors are declining, giving active managers a better opportunity to prove their worth," Gary Flam, portfolio manager at Bel Air Investment Advisors, said in an interview.

"Correlations can go back higher, but we've seen over the last year or so an inching towards normalcy in the markets," he added. "That has created opportunities for stock pickers."

(Read More: Is This the Most Hated Bull Market Ever?)

Those opportunities translate into the best beat rate in years, far exceeding the 27 percent who topped their benchmarks in the first quarter and the 32 percent who did so in 2012, according to Bank of America Merrill Lynch.

Don't 'Overreact' to the Fed: Pro
"You cannot remove an elephant from a room quietly," said David Kelly, JP Morgan Funds, discussing the Fed's exit strategy and details from yesterday's FOMC minutes and its impact on the markets and economy, with Dan Colarusso, Reuters.

Nor surprisingly, core and value managers have been the best of the group for the full year, with respective 37 percent and 36 percent beats. The out performance has been helped by a market beta chase, in which large-cap stocks with no dividends, poor analyst ratings and low multiples have topped their higher-quality counterparts.

To be sure, the trend could unravel quickly if the Fed does not follow through on tapering its $85 billion in monthly bond purchases. The central bank's policies had helped tamp down volatility and with it the ability of active traders to make money off mispriced individual stocks.

(Read More: Fed Officials Worried About Easing)

Passive management differs in that it focuses on indexes. The group has thrived as money has poured into index-tracking exchange-traded funds, which now boast $1.48 trillion in assets.

Growth managers have seen the worst performance in the active management realm, with just an 18 percent beat rate and an average underperformance of 1.6 percentage points, BofAML said.

The trends have come as the Fed has alerted the market that it is contemplating an exit from its $85 billion a month bond-buying quantitative easing program.

Interest rates have climbed and stocks have been volatile, with financial markets tuned in to macro concerns about a slowing global economy and Middle East unrest.

Conditions going forward, though, could change as monetary policy starts to normalize.

(Read More: Will Investors Finally Buy Bernanke's Explanation?)

"We expect the macro-driven market to subside in the second half of the year, creating a more favorable environment for active managers," said Savita Subramanian, equity and quant strategist at BofAML.

Despite the brighter outlook for active management, hedge funds had a rough June, losing 1.3 percent for the month to cap off a 0.2 percent quarterly decline in the $2.7 trillion industry, according to eVestment.

However, much of the losses came about through quakes in the debt markets.

Credit strategies had their worst month since September 2011 as government debt yields surged, which also took its toll on macro strategies.

Hedge fund managers have taken a beating this year in good part because of heavy Apple ownership. Though the stock remains the most-owned hedge hedge fund issue, it also has been the most-sold this year, according to industry research firm NerdWallet. The second most-sold has been the SPDR Gold Trust exchange-traded fund.

The top purchases this year have been Johnson & Johnson as well as Time Warner.

In small-caps, the most-owned by top funds is Caesars Entertainment. Funds controlled by George Soros and John Paulson own 14.43 percent of the company, according to NerdWallet.

Stock picking will certainly be a much-discussed topic at this year's Delivering Alpha conference, co-sponsored by CNBC and Institutional Investor, to be held July 17 at the Pierre Hotel in New York City.

By CNBC's Jeff Cox. Follow him @JeffCoxCNBCcom on Twitter.

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