Why the Days of Stock Picking May Be Coming to an End

Another woeful year for active managers is coming to a close, sparking concerns that the day of the stock picker is over.

Why the Days of Stock Picking May Be Coming to an End
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Just as in 2011, only about 1 in 5 active managers are beating their benchmarks in a year marked by the same type of headline volatility caused by events in Europe and fiscal concerns closer to home.

While the advantage of passive over active is nothing new, the near-record level of futility is, and the cracks are beginning to show.

"Clearly it's been a tough couple of years for active," said Gary Flam, portfolio manager at Bel Air Investment Advisors in Los Angeles. "For investors, you really have to have a forward-looking view."

That means investors will have to shrug off recent results and count on the importance of having advisers who can see through the fog of politically driven markets with tight correlations, where all asset classes essentially move together up and down. (Read More: Goldman to Clients: Brace for Another 8% Drop in S&P)

Those correlations make it much more difficult to have a diversified portfolio — and add further challenges to active managers to match returns of passive funds that simply follow popular indexes.

"The market is being driven by macro factors," Flam said. "So most professional advisors have a background in evaluating companies, industries, economies. It's not in politics, and politics is what dominating the markets over the last couple of years."

So as active managers struggle, investors have flocked to products more tied either to broader indexes like the Standard & Poor's 500, or to specialized sub-indexes that track sectors such as energy, financials or consumer stocks.

Passively managed funds make up 16.4 percent of all mutual fund assets, a number that has surged by two-thirds over the past decade and by 44 percent over the past five years, according to Strategas Research Partners.

The $1.256 trillion exchange-traded fund market includes a handful of actively managed products but is mostly concentrated in the passive space. Assets have jumped 18.3 percent this year and the amount of funds has increased 5 percent, according to XTF.

It's no surprise why investors have turned to passive investing.

"The active managers who beat the market are more tactical-oriented and they tend to be more concentrated and they put larger positions in particular sectors. The problem with that is, if they're wrong they get hit more," said Nadav Baum, executive vice president at BPU Investment Management in Pittsburgh, Pa.

"It's a lot easier for the average retail investor to go out there and buy a basket of ETFs and have a broad-based market exposure. With this explosion of ETFs you can then spike out into other sectors and do your own tactical management."

To be sure, the strategy is not fool-proof.

The classic catch to the passive side, according to active managers, is that buying and holding only works until the inevitable bursting of asset bubbles.

Some believe the stock market, spurred on at virtually every step by cheap money from the Federal Reserve and its $2.9 trillion balance sheet, is in a major bubble that soon will pop. (Read More: 'Fiscal Cliff' Fever Breaks—Does the Bounce Have Legs?)

"What we do best is model the difference between inflation and deflation which is caused by the Federal Reserve," said Michael Pento, president of Pento Portfolio Strategies. "I don't think it's even possible anymore, the idea that you can buy and hold a diverse group of assets and hold them for 10 years."

Pento believes the current climate sets up for a rising stock market but ultimately will lead to inflation and a need for investors to migrate to hard assets and energy.

Many investors, mindful of a need to vary their choices, are clamoring for indexes that are composed not just of basic indexes but now apply overall strategies.

"What's interesting about indexes now is that we've gone through three distinct phases," said Shaun T. Wurzbach, vice president of channel management and solutions at Standard and Poor's Dow Jones Indices. "The first was the creation of the S&P 500 (and other major indexes), the second phase was the creation of sector-based indices for narrower exposures. The third wave is a wave of strategy-based indexes."

Some of those gaining popularity are geared towards low volatility, bank loans and weighted by country, Wurzbach said during an interview at last week's Charles Schwab Impact 2012 conference, where there was substantial chatter about investor desire for new options away from simple stock and bond portfolios. (Read More: Are Investors Actually Taking the 'Fiscal Cliff' Too Lightly?)

"Sometimes innovation is well-received in the marketplace and sometimes it isn't," Wurzbach said.

In any event, active managers have their work cut out for them if they want to stay relevant as returns continue to diminish.

Jeff Coons, president and co-director of research at Manning & Napier in Fairport, N.Y., said investors shouldn't judge the industry as a whole and instead should focus on individual managers with sound strategies to navigate bubble and post-bubble markets.

"Demonstrating the value of active management ultimately requires a thorough manager evaluation, he said. "While the quest for absolute-return-focused solutions can be challenging at times, it's important to remember that no single mix of assets is likely to meet an investor's goals in every market environment."