This is the time of year when fund managers who haven't beaten the market scramble to dress up their portfolios.
Sometimes known as the "catch-up trade," these money guys dump their losing stocks and buy up big gainers to make themselves look better to investors and justify their high fees. And with most managed funds underperforming index funds this year, there's likely to be a strong catch-up trade in the coming days.
"Given the rally that we've had in the last half of the year, fund managers are going to want to look like they're totally invested and that they didn't miss the whole thing," says Uri Landesman, president of Platinum Partners hedge fund in New York. "You'll probably see a fair amount of activity, which indicates towards possibly closing even higher."
While this practice may make you think twice about investing in managed funds, there are ways for average investors to take advantage of the pros' bad calls.
Here are four strategies from some market pros on what fund managers and institutional investors will be doing to close out the year.
For Hedge Funds: M&A and Small Business Loans
While Landesman says his hedge fund is going to "be doing what we've been doing," he said current valuations are creating a friendly environment for mergers and acquisitions, while an anemic lending climate among banks is opening the door for loans to certain companies.
"We see a lot of opportunity to make small loans to very solid companies that for whatever reason don't have access to capital markets," he said. "We see lending institutions still not willing to go down in cap size to make deals. That's an opportunity for us."
Most of the loans are in the $3 million to $10 million range on a six- to 18-month time horizon. There's plenty of demand but not enough supply, he said.
Also, he thinks the M&A environment will continue to improve, proving opportunities for bigger companies or simply investors who can spot potential deals.
"People are going to start looking for undervalued things that would be of interest to a buyer—bigger-value companies with better balance sheets," Landesman says.
For Institutions: Perusing the 'Naughty' List
One the favorite late-year strategies for institutional investors is to search for the stocks that have been beaten up the worst over the year and then buy up those that have a chance at rebounding.
"The logic here is that these are the stocks that investors will sell in December to take tax losses, offsetting winning investments in the current tax year. Once the selling abates—sometime between the final week of December and early January—the stocks should bounce back," Nicholas Colas, chief investment strategist at New York-based institutional investor advisor BNY ConvergEx, wrote in a note to clients.
"In the fundamentally oriented investment arena, contrarian stock picking is largely predicated on the notion that even the most poorly perceived company in the worst industry is worth an investment if there is a chance something/anything can go right. Or just stop going wrong," he added.
Colas composed an extensive list of heavily sold stocks that he calls the "naughty" list, specifically the 20 worst-performing stocks in the S&P 500, 400 and 600, along with the Russell 2000. The worst in the respective categories are: Dean Foods , Corinthian Colleges, First Bancorp and Flagstar Bancorp.
Stock Picking; Focusing on Financials
For Smaller Funds: Stock Picking
Just a few months ago it seemed as if the era of stock picking was fading away. The similar movements up or down of all asset classes, and within stock market indices, was making portfolio diversification a highly elusive goal.
But correlations have broken down since the stock market's rally that began in late August, presenting opportunities for fund managers to get some value for their clients and move away from buying broad indices.
"There's a time and a place for indexing, and that time and place is when everything is cheap," says Steven M. Roge, portfolio manager at the Roge Partners Fund, with about $200 million assets under management. "With the S&P at 700, everything is cheap. You can throw a dart and pick a good stock. When valuations are at 1,200 or so it becomes much more difficult to do that. You have to be selective in the stocks you buy."
Prior to the three-month stocks rally, active managers had been having their worst year ever. But the tide has changed a bit.
"Active management today is more important than it has been the past two years, particularly among conservative managers who are being very prudent in how they allocate capital to investments," Roge says. "I don't think you want to be the traditional institutional fund that tracks the style box."
For Everyone: Focus on the Financials
Even as the market has staged two significant rallies this year, financials have trailed badly, with most of the sector's 5 percent gains coming recently and still placing it eighth of the S&P 500's 10 sectors.
That makes the industry ripe for late-year tax selling, and for providing enticement to managers looking for stocks with room to rise, according to banking analysts at Keefe, Bruyette & Woods.
"Given the underperformance of financials relative to the market, we believe there may be increased opportunities this year for retail investors to improve after-tax portfolio returns by harvesting tax losses in financial stocks to offset gains in other sectors," analyst Melissa A. Roberts wrote in an analysis for clients.
As such, the selling will provide "a liquidity event and allow institutional investors to more easily build positions in these names," she added.
Here are 14 stocks that KBW believes are prime tax-sale candidates:
The one thing that will be required is for managers to be willing to take on risk, something that could be in stronger supply with volatility indicators extremely low.
"You're going to see window dressing and some managers putting risk trades on going into the end of the year," Roge says. "The markets had a nice rally. It seems the momentum in the short term has been to the upside. I wouldn't be surprised to see some active managers put some risk on."