This year may turn out to be the year of the stock picker.
Market volatility has made it difficult for fund managers to beat the return on index funds over the last two years.
And as a result, many investors, unhappy about paying higher fees for underperformance, have migrated towards less costly index funds and exchange traded funds (ETFs).
But the tables could turn in 2010 as the market returns to more traditional patterns after sharp swings lower and higher in 2008 and 2009.
As the market "normalizes," investors will start looking for quality picks to assure stronger returns, analysts and traders say.
In late 2008 and early 2009, the value of many companies plummeted as the economic meltdown threatened their very existence.
But, with some exceptions, the doomsday scenarios didn't play out, largely due to extraordinary government measures. Stocks were revalued and indexes rose quickly, with many battered stocks outperforming higher-quality names that had held up better during the market upheaval.
"The easy, low-hanging fruit — in terms of 'we're not going to have a depression, we're not going to have a nationalization of the banking system, therefore risk assets are going to do well' — that low-hanging fruit has been picked," said Bob Doll, global chief investment officer of fundamental equities at BlackRock Inc in New York.
He sees gains as being much more difficult to come by in 2010, making stock selection based on company fundamentals more critical than in the past couple of years.
Another factor that may lead to bigger gains by active managers is the expectation of rather modest economic growth in 2010, which is unusual when coming out of a recession, said Norman Raschkowan, chief investment officer at Mackenzie Financial in Toronto.
"This year you are going to see people recognizing that quality businesses in a slow-growth environment ... are the ones that are really going to prosper," he said.
Being able to make the right picks is one of the ways mutual funds justify their fees. But some liken picking stocks to throwing darts at a board while blindfolded — you might hit the bull's eye, but chances are you won't.
Raschkowan argued that picking stocks involves more than that.
"Part of the fees in a mutual fund relate to the service that they're receiving from their adviser," he said. "I think really good advice can pay dividends to an individual and it's really up to the individual to assess whether they're getting value for that advice."
Bank of America Merrill Lynch, in a research note, said that a return to active management is one of the top 10 themes of 2010.
That's because volatility has come down considerably from the height of the financial crisis and lower volatility leads to lower correlation between stocks, resulting in greater differentiation in price performance, said Savita Subramanian, a quantitative strategist at BofAML U.S.
"The trend favors active over passive management," said the note. "If the surprise of 2010 is that there is no surprise, sell volatility. A stock-picking environment would cause high quality, best-of-breed stocks to outperform."
BofAML recommends using actively managed funds or actively managing passive ETFs.
Another trend that has been gaining popularity has been a move toward actively managing ETFs as a lower-cost alternative to mutual funds, with offerings from firms like Pimco, HS Dent Investment Management, and BlackRock's iShares.
In an actively managed ETF, advisers manage the assets in the fund, like a mutual fund, but the fund trades on a stock exchange.
Other firms looking to get into the active ETF space include Putnam Investments, Vanguard, John Hancock Funds LLC, and T. Rowe Price.
"I suspect that's a trend that will continue to grow," Raschkowan said. "The jury is still out on whether those products will in the end add value for clients."
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