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Passive investing had been declared the winner in the race for returns, beating stockpickers. But the race is still on, and suddenly, the stockpickers are surging ahead. After a slow start to the year, 60% of actively managed funds are beating the Standard & Poor’s 500 index since July 1, the highest level in nearly two decades. This at a time when money has been pouring into index funds at record rates.

Granted, passive investing has outpaced active in 22 of the past 26 years, in large part because of fees—1.14% for the average actively managed large-cap fund, compared with less than half that for passively managed funds, going as low as 0.03% for some broad-market exchange-traded funds. Then there are years like 2015, when the S&P returned 1.4%, entirely on the backs of a handful of super-performing stocks. Managers who didn’t own Facebook (ticker: FB), Amazon.com (AMZN), Netflix (NFLX), andAlphabet (GOOGL) found themselves lagging—just 39% of all active large-company funds beat the market that year. But that anomaly has passed, and active management is back.

We predicted as much, albeit a bit early, in a Jan. 10, 2015, cover story, “Return of the Stockpickers,” in which we forecast that the coming rise of interest rates would lift the small stocks they favored, and increased volatility would give active managers more opportunities. And in March of this year, we predicted that value investing, which had lagged growth for nine long years, was poised to outperform (“It’s Time for Value,” March 12).

This prediction was more timely: Since the beginning of this year, 62% of value funds tracked by Morningstar are beating the index. However, just 6% of active growth funds are outpacing the market year-to-date, though they have staged a recovery in the second half.

So what happened? In short, a return to risk after a first half mired in caution. Gains have been more widely dispersed throughout the market, which adds up to a situation in which active management can thrive. If the Federal Reserve, as widely expected, boosts interest rates in December, there’s a good chance that active managers can keep outperforming.

That’s quite a nice change, in a world where passive funds have sucked in cash and active managers have been swamped by redemptions. In a low-growth, low-rate environment, people flocked to tax-efficient, low-cost passive funds, and those benchmarked to the S&P 500 were the most popular.

New rules for fiduciaries also enhanced the appeal of passive funds. Active managers were hit by redemptions, hurting stocks that they owned. Conditions for active managers have been “tougher than I’ve ever seen in my 30 years in the business,” says John Hailer, CEO of Natixis Global Asset Management.

And certainly, there’s plenty of headroom for passive funds to grow: Just 30% of U.S. funds are passively managed today.

Yet big-cap funds have done better than they get credit for: On average, according to Morningstar data going back to 1990, about a third of them beat the index every year, with notable outperformance in 1993, when stocks treaded water, and again in 2000-2001, and in 2007, when markets collapsed.

AS INTEREST RATES stayed low, investors flocked to low volatility and high-yielding sectors like consumer staples, as well as to the S&P 500. Valuation disparities grew wide, which made active managers wary. According to Invesco, defensive stocks are priced about 45% higher than cyclical issues. Previously, since 2011, the valuation disparity previously had bounced between zero and 30%. Bond proxies like utilities and telecoms also benefited.

“The average core manager has been underweight utilities and staples for as long as I can remember,” says Bank of America Merrill Lynch analyst Savita Subramanian. “Why would you pay a higher multiple for a stock that wasn’t growing, versus a lower multiple for a stock that is actually growing earnings?”

Then came 2016—and conditions turned in stockpickers’ favor. Early this year, the price of oil dropped by almost a third in six weeks, raising concern about emerging markets and the global economy. Stocks around the world sank, junk bonds weakened, and the dollar surged. Investors fretting about U.S. growth crowded into safe investments and dividend payers. Midway through February, equities calmed. But the following quarter, Britain voted to exit the European Union. Stocks sank again. And that created an entry point. Economic readings began to improve: September joblessness was 5%, near what’s regarded as full employment. The Fed spied signs of increased inflation and said it would raise rates soon, a step toward normalizing policy. Technology and financial stocks burst out of the gate, as did other economically sensitive, cyclical companies. Utilities and telecoms plunged. In some ways, Brexit even helped the market: Japan’s SoftBank Group (9984.Japan) agreed to buy British chip designer ARM Holdings for $32 billion as sterling sank. Belgium-based Anheuser-Busch InBev (BUD) increased its offer for London’s SABMiller. All this “created a real air pocket of outperformance,” says Subramanian.

THAT RESTORED LUSTER to stockpickers. But fund investors have another step to take; they must choose the managers they consider poised to outperform. Research led by Martijn Cremers at Notre Dame has demonstrated that funds with high active share—a measure of how much a portfolio deviates from the benchmark—are most likely to beat the market. Of course, being different from a benchmark isn’t everything; the manager must also be right. That often correlates with conviction: Funds that have high active share and are most likely to outperform have fewer holdings and low turnover. And often these are the funds that fell most out of favor in the recent rise of indexing.

The perfect example: Longleaf Partners (LLPFX), the top fund since July 1. It has stormed to an 11% gain for the second half, bringing its year-to-date increase to 18.2%, more than three times the S&P’s gain. This marks a sharp reversal from a horrible period that caused Morningstar to downgrade the fund. “This world creates opportunities when people give up on stock-picking,” says Staley Cates, chief investment officer of Southeastern Asset Management, the fund’s manager. “The index has pushed some industry groups into crazy territory.”

Cates and his colleagues are true stockpickers: They seek out strong, competitive, financially sound businesses with growing cash flow, run by good operating managers who know how to allocate capital. Initially, they try to buy investments for 60% or less of their appraisal value. They are devotees of the value-investing principles first described by Benjamin Graham and David Dodd. Employees are the largest investors in Longleaf. The $3.5 billion fund owns just 14 stocks—a recipe for volatility. Its performance in recent years has been poor, though it has pockets of excellence. But in the past year, it has beaten 99% of its peers, according to Morningstar, and in 2012 it outstripped three-quarters of them.

Longleaf positions that have surged include FedEx (FDX), where margins increased in express and ground divisions, amid expectations that its acquisition of TNT Express will create sizable synergies. Analysts had suggested that an Amazon delivery network could threaten FedEx. But “the negatives are just dumb. They keep reporting fantastic numbers in units and prices,” says Cates.

The fund’s companies still trade in the low 70% range of Longleaf’s estimates of their value. A Fed interest-rate increase, says Cates, may “start bringing sanity to stock selection.”

The second-half rally put many funds squarely in the black, including Invesco Growth & Income (ACGIX), whose second-half gain of 7.5% brought its year-to-date return to 8.2%, driven higher by stocks such as Apache (APA), Citizens Financial Group (CFG),Morgan Stanley (MS), State Street (STT), and Qualcomm (QCOM). Manager Tom Bastian is bullish on financials, maintaining that they are cheap, even though balance sheets “have never been in better shape,” and the companies are poised to increase dividends and buy back shares. One favorite: Morgan Stanley.

One long-term outperformer and beneficiary of the second-half revival is Gavin Baker of the $13.6 billion Fidelity OTC Portfolio (FOCPX). Yet when asked about his second-half performance, Baker is aghast. “The shortest time frame I look at is three years, and I try very hard to focus on three-, five-, and seven-year time frames,” he says. “Anything under is noise.” Fair enough: The fund is tops in its category over 10- and 15-year periods, and beating 97% of its large-growth peers over three years.

This year’s performance has been driven higher by chip maker Nvidia (NVDA), oncology company Tesaro (TSRO), and generic drug outfit Endo International (ENDP). Baker says he knew it would be a year for stockpickers when, as 2016 began,Salesforce.com (CRM) stock fell from $78 to $54, and Amazon.com tumbled from $675 to $482. “It was completely irrational. If you’re a long-term investor, you can take advantage and be a liquidity provider,” Baker says.

Will the outperformance continue? To be sure, times will stay tough for active managers. Many fund companies are bloated, with too many funds that are persistent laggards. And all funds will fare poorly if the market slumps badly—which isn’t impossible, given that the U.S. election and a Fed rate increase lie ahead. History, however, says that active managers will beat the market during a decline, just as they did in the downturns of 2000 and 2007, when 66% and 53% of actively managed funds outperformed.

In his third-quarter letter to shareholders, Jerome Dodson, president of Parnassus Investments, a growth-at-a-reasonable-price investor with a sustainable focus, who runs the top-performing $1.9 billion Parnassus Endeavor (PARWX), called the market “fully valued and possibly even overvalued. I know this because I’m having a hard time finding good companies at reasonable prices.”

Earlier, cash in the fund had soared above 15%, about three times what he likes to hold. In theory, Dodson continued, an increase in interest rates would be bad for the market. Yet, he added, stock prices have been “distorted” by eight years of unnaturally low rates and a rate increase “probably won’t depress the market for long …. If this happens, and stocks go down to more attractive valuations, it may provide us with an opportunity to put some of that idle cash to work.”

For active stockpickers, the best days might still be ahead.

REF: http://www.barrons.com/articles/active-stockpickers-are-outpacing-passive-funds-1478318812?mod=BOL_hp_highlight_1