As investors move to passive funds, stockpickers get creative

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[February 06, 2015]  By David Randall

NEW YORK (Reuters) - Undaunted by the popularity and outperformance of index-tracking investments, mutual fund companies last year rolled out 193 new actively managed stock funds, many with some highly colorful concepts.

The fund companies aren't giving up their efforts to win investment dollars with their stockpicking prowess. Rather, they are floating funds that are increasingly niche-oriented in the hope of getting shelf space next to the generic S&P 500 index and other passive funds that are sucking cash out of active funds. Last year, passive funds brought in $166 billion in new investor dollars, while investors pulled $98 billion out of traditional funds run by stockpickers.

The idea behind the push to specialized funds is that as index funds and exchange traded funds increasingly take up market share in the broadest categories, fund companies can still find profits in the spots where passive funds can't - or won't - compete.

Of the new actively managed stock funds introduced by firms in 2014, more than half focused on niche strategies or markets, according to Morningstar data. New funds in 2014 included the ATAC Beta Rotation fund, which attempts to move in and out of sectors based on inflation expectations, and the 3D Printing and Technology fund.

 

A new actively-managed fund typically requires as much as $60 million in start-up costs, and will often need that much in assets before they become profitable. Index funds, by comparison, typically have much higher break-even points because of their lower fees, said Luke Montgomery, an analyst at Sanford C. Bernstein & Co.

If a fund doesn't become a hit with investors, then companies can always pull the plug. The average fund lasts just 7 years before it's closed, according to Lipper data. Most firms either sell the fund, merge it with another one, or send cash back to their shareholders for the value of their holdings.

"There's not a lot of whitespace left that isn't being taken up by passive funds or well-established active funds. Unless it's a fund manager starting up his own shop, the only way for most funds to break in is to market a more sophisticated strategy," said Todd Rosenbluth, director of mutual fund research at S&P CapitalIQ.

STOCKPICKING REWARDED?

Portfolio managers of active funds that do come to market say that they think the stockpicking will be increasingly rewarded as the current bull market which began in 2009 begins to wane.

"I would like to think that people who are in our fund recognize we are five years into a bull market built upon central bank intervention. I think that investors in our fund are a more sophisticated type who looking for risk management techniques," said Edward Dempsey, co-manager of the ATAC Beta Rotation fund, launched last year.

Funds like Dempsey's face an uphill battle for assets. In 2014, the average active fund underperformed its passive counterpart by an average of 3.1 percent, the widest margin in more than 10 years, according to Lipper.

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"Even the most ardent proponents of the efficient market hypothesis will say that there are pockets of inefficiencies, and the most common is small-cap and international stocks," said James Oberweis, the president of Chicago-based Oberweis Funds, which launched a international stock fund last year.

Indeed, 77 of the funds that launched last year - or 40 percent of the total - were categorized as emerging markets, international, or small-cap funds, according to Morningstar. There were 48 new large cap funds, with the majority of those focused either on dividend strategies or so-called concentrated funds, which only hold a handful of stocks and are considered riskier options.

Los Angeles-based Causeway Funds introduced a new fund focusing on international small-cap stocks in 2014 in part because it saw it as a market where there was little competition from passive competitors and its stockpicking process would be more valuable, said Harry Hartford, president and a portfolio manager at the firm.

"Our thought process was, 'Is there a niche that we can fill in the marketplace, and do we have the resources to fill that niche?'" he said. The Causeway international small-cap fund is lagging its benchmark by 0.1 percent since it launched in October.

ATTRACTING DOLLARS

Fund managers say that outperforming the benchmarks is the most reliable way to attract investor dollars in a time when passive funds are gaining more traction. While brokers may have an incentive to push actively managed funds because they can get earn commissions for selling them, few investors will opt for a fund that has a poor track record.

John Langston, a Fort Worth, Texas-based fund manager who launched the Panther Small Cap fund last year, said, "If you're putting up good performance numbers, that's the best way to get your story out there and hope investors follow."

(Reporting by David Randall; editing by Linda Stern and John Pickering)

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