Trading Nation

Performance of retail stocks is a perfect example of the perils of passive investing, says strategist

Trading Nation: Big bounce for retailers

The retail rout could serve as a prime example of just how much value skilled stock pickers can add.

Take the XRT, a popular exchange-traded fund that tracks retail stocks. Investors in this equal-weighted passive index for retail names have seen the fund decline nearly 8 percent in the last year. Its components' performance is extremely varied; Amazon, for example, is up 47 percent in the last year, while one of the XRT's beaten-down brick-and-mortar retail names, Abercrombie & Fitch, is down 61 percent in the same time.

The fund on Wednesday gained 2 percent for its best day in four months, helped by gains in Nordstrom, Dillard's and J.C. Penney. But even with this bounce, it's still 3 percent in the red year to date, and down 15 percent in the last two years. Apparel retail comprises the largest percentage of the fund's holdings (just over 23 percent), followed by internet and direct marketing retail names, making up nearly 17 percent of all constituents.

"I mean, if you've been a passive investor in the retailers over the last two years, you've done very, very poorly," Miller Tabak equity strategist Matt Maley said Wednesday on CNBC's "Power Lunch."

Indeed, the case against passive investment has long been made for precisely this reason. Active managers can pick stocks for their clients, but when it comes to passive investments like ETFs, investors cannot pick and choose individual names. Of course, passive investment can be cheaper than paying a human to manage your money, and the appeal of "thematic" investing, or buying a group of securities with a like theme, is growing.

Changes are coming swiftly. BlackRock, the world's largest money manager, on Tuesday announced significant changes to its actively managed equities arm, cutting jobs and relying more so on machines to manage equity positions for clients.

A comparison chart of Amazon and Macy's speaks to Maley's point. The stocks trade with each other from about 2008 until mid-2015, and then diverge dramatically.

"I think that if you continue to work in a passive way in that group, and I think in other groups in the future, it's going to be a problem for you," he said, as he doesn't see big changes in the near term for brick-and-mortar retailers that have faced competition from e-retailers.

Average sector correlation has in fact drifted lower, as Nicholas Colas, chief market strategist at Convergex, has written. In other words, the gap has widened between equities' intra-sector performance in part due to a sector rotation after the U.S. election. And that's part of why, as he put in a note last month, "getting sector and stock bets right just got a whole lot more serious."

"As correlations drift lower, different sectors will tend to show greater price and performance dispersion," Colas wrote.

When it comes to retail names specifically, investors should be particularly careful about stock picking, agreed Erin Gibbs, equity chief investment officer at S&P Global.

"When you look at retailers in general … one, they've already outperformed the broader index, and their valuations are really pricey," she said, adding that the S&P 500 retail group is trading above 26 times forward earnings.

"You really need to be a little choosey. And when you look at earnings growth and the industries within the retailers, there's a huge distribution; we have some groups that are expecting 28 percent growth, and other groups that are expecting 8 percent contraction. And so that's why you really want to select well," she said.

In this space, Gibbs recommends home improvement industry like Lowe's and Home Depot, which prove to have some of the highest growth, but still have "decent valuations."

"And of course, the online retailers are the ones that are really killing it and are also driving a lot of the returns for this year," she said Wednesday on "Power Lunch."