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Volatility was supposed to be a lifesaver for stock pickers — here's why it hasn't been and why that could be signaling more market pain

on 1/10/2019

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  • Stock market volatility has returned with a vengeance, but it hasn't helped active managers as much as many thought it would.
  • We explain why this is the case and why it's a bad sign for the longevity and health of the stock market.

In 2018, after a year spent in a nearly motionless state, the stock market rediscovered volatility.

It was supposed to be a watershed period for investors who make their living selecting stocks based on core fundamentals. Price swings picked up in earnest, theoretically creating endless opportunities for savvy traders to exploit.

But it didn't turn out that way. In fact, the increased volatility — which saw the Cboe Volatility Index, or VIX, surge by 50% in 2018 — made things worse for stock pickers.

Recent data compiled by Bloomberg shows only 35% of actively managed large-cap mutual funds outperformed the benchmark S&P 500 last year. That's down from 42% in 2017.

Those underwhelming returns raise an unfortunate reality about volatility. Sure, increased price swings create more opportunity for investors. But at the end of the day, those traders still have to select the right stocks, which they clearly haven't been.

Read more: We interviewed Wall Street's 8 top-performing investors to get their best ideas for 2019

And other investors have noticed. For the 12 months ended in November, more than $180 billion was pulled out of active equity funds, according to Morningstar data. Passive vehicles absorbed more than $320 billion over the same period. That included back-to-back months of record-setting inflows for BlackRock's exchange-trade fund business, iShares.

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The people with skin in the game had spoken. They were tired of lagging performance from active managers and opted to turn their funds over to their newly instated passive overlords.

But the question of why active managers have been trailing still lingers. And while the explanation is far from simple, it boils down to one new reality facing equities: They're being whipsawed more by macro drivers than by anything relating directly to their own businesses.

When that's the case, even the most prudent stock selection can get overruled by external forces. To that end, the market faces a plethora of macro overhangs, including President Donald Trump's trade war and the Federal Reserve's monetary tightening.

So what does this mean for the long-term health of the stock market and the longevity of the 10-year bull market? Let's just say it's not the most encouraging sign.

Perhaps the biggest criticism of passive investing is that it piles into proven winners, leading to unsustainably crowded positions. Then, when selling starts, everyone rushes to the exits simultaneously, exacerbating losses.

It's also been surmised that passive investing creates pockets of stretched valuations in the market segments most commonly tracked by ETFs and their passive brethren. Those tend to be the areas hit hardest when investors decide the market is overvalued. Not to mention the lack of diversification that can arise from everyone owning the same stocks is a recipe for disaster.

So while investors can find comfort in passive funds for the time being, there will eventually be another market reckoning that sends everyone scrambling. And when that happens, the market will once again be shocked with the type of volatility that sinks portfolios.

Because if 2018 showed us anything, it's that not all types of volatility are created equal, at least when it comes to helping investors.

SEE ALSO: An investor crushing 99% of his peers breaks down 3 stocks he loves right now — one of which is 'beating Amazon at its own game'

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Full "The Business Insider: The Money Game" article


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