Active vs Passive Investment Management

Some people have referred to the year 2019 as the “Everything Rally” for the investment world and the description is accurate. Pretty much every asset class you can think of has beaten its historical return this year. Domestic stocks and international stocks, large-cap stocks and small cap stocks—they have all beaten their historical returns in 2019. Commodities as a whole have beaten their historical average returns. Corporate bonds and treasury bonds have both beaten their historical averages.

The chart below shows the YTD returns for seven different ETFs that represent the different asset classes. The worst performing one was the Invesco DB Commodity Index Tracking Fund (NYSE: DBC) and it gained 11.2%. The SPDR S&P 5oo ETF (NYSE: SPY) was the top performer with a gain of almost 31%.

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It is quite rare to see all asset classes rising at the same time. We usually see stocks rallying and bonds falling. The reason is quite simple, when stocks are moving higher, bonds are less attractive and tend to fall. Commodities like gold tend to fall when stocks are rallying as gold is more attractive when there is uncertainty surrounding the global economy.

The “everything rally” has helped the trend toward passive asset management continue. This trend started well before 2019, but with every asset class gaining ground, it made it easy to justify switching to a passive strategy.

If you aren’t familiar with the term passive asset management, it is an investment practice that involves investing in indices or index funds rather than focusing on individual stocks. The practice of focusing on individual stocks or even individual industries is referred to as active asset management.

The rise of ETFs has certainly contributed to the shift to passive management as they have provided a new tool that allows investment managers and individual investors to build portfolios with ease and with lower costs than mutual funds.

The shift away from active management to passive management has been going on for a number of years now, but I look for a bit of a shift back to active management in 2020. My thinking is that 2020 is going to be a year where returns for the market as a whole return to a more normal range, but we will see certain stocks that outperform the indices and the sectors by a wide margin.

I laid out my investment process for you in an article last week—using a process that includes fundamental, sentiment, and technical analysis. While I use this process in all market environments, I think it works better in a market environment that rewards individual stock picking.

To give you an idea of how I use the information, I put together the following table of software stocks. I mentioned in the article last week that I like the software industry for 2020. It lagged the overall tech sector in 2019, but there are a great number of companies with strong fundamental ratings as we head into 2020. This table is similar to the process that I use to select stocks for my model portfolio.

The EPS and SMR ratings are from Investor’s Business Daily. The EPS rating measures how the company’s earnings have grown in the last few quarters and the last few years, and it compares them to all other companies. The higher the number, the more the earnings have grown. The SMR rating measures the company’s sales growth, profit margin, and return on equity against other companies. Like it was in school, an A is good and a D is bad. The worst grade is an E though, not an F.

I can tell you that both Adobe and Workday are in my model portfolio currently. There are others on the list that I am keeping an eye on, but for stocks like Cloudera, Everbridge, and FireEye, I won’t be considering them for the portfolio. I may consider shorting them if I won’t short exposure, but I won’t be going long these stocks.

Once I have established which companies I am interested in that’s when I add the sentiment analysis and the technical analysis. For the sentiment, I want companies that aren’t overly loved. I want there to be some bearishness toward the stock because that means a rally can continue. For the technical analysis, I watch the weekly chart and look for buying opportunities. I don’t like buying a stock when it is overbought and prefer to buy when it has experienced a pullback or when it is sitting at a support level.

The process isn’t rocket science and it isn’t foolproof. Sure there are stocks that don’t end up working out, but there is a process for selecting the stocks and there is a plan for getting into an investment and for getting out. This is the type of management style I believe you will need to beat the overall market this coming year.

I think in 2020 having a process and having a plan are going to be very important—even more important than usual.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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