will-2017-knockout-the-index-fund

We have been writing about the changes in the US equities market since the election (here, here, here, and here).  In our update titled, “From Dow to Infinity,” December 12, 2016, we illustrated many economic fundamentals reversed during the summer years of stagnation and the stock rally and bond market selloff since the election is based on sustainable improvements.  Our view is the election was a catalyst vs. an impetus to the rally meaning it added to an already improving economy instead of being the sole source of optimism.

If this rally continues in the same manner, there will be a widening between winners and losers.  For years many sectors have been correlating together in a tight spread which has challenged active managers to outperform their respective indices.  Many articles have suggested the end of active management as non-managed index funds provided superior performance at lower fees.  Although there are many positive attributes with index funds, the negatives are that the ownership of index funds exposes an investor to both good and bad positions. Open exposure is not a preferred strategy when the market disconnects the good from the bad and underperforming sectors diminish overall returns index funds would previously yield.  Active managers will have the opportunity to reduce sectors that are underperforming and add to the better performing areas of the market.

We have already witnessed significant separation between the three major S&P indices that once held tight correlation. As illustrated in the graph below, since the election the Small Cap 400 ETF (blue line) has increased 15.57% and Mid Cap 600 (orange line) 10.9% significantly outperforming the S&P 500 ETF (red line) with its return of 6.12%.

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Another area where trends are reversing faster than a Trump campaign promise can be found between the Russell 2000 Value ETF (IWD) and Growth ETF (IWF).  For the past ten years, the Russell 2000 Growth ETF (orange line) has consistently been the better performing sector and outperformed the Russell 2000 Value (blue line) by nearly 300% (see chart below) for this period.

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This trend continued up to April 2016 when Russel 2000 Value began to outperform Russell 2000 Growth.  After years of Value being trounced by Growth, the trend started to reverse.  For 2016, Value turned in a 17.13% return vs. 9.81% for Growth.

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However, the real break in this trend occurred after the election.  The Russell 2000 Value popped almost 8.43% in the last two months of 2016 while the Russell 2000 Growth increased a mere 3.82%.

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WHAT DOES THIS MEAN TO ME?

While we continue to view Index ETF’s as core investments, opportunities that may reward active managers are developing at a steady pace.  Investors remain uncertain about the impact of new US policies as world currencies fluctuate widely based on projected changes in monetary flows between countries.  However, based on the US stock market rally post-election, it appears that institutional investors are optimistic that new policies assembled in DC will add rocket fuel to the nearly eight-year low-growth economy.  We remain positive on the current state of the US stock market.  Conversely, the bond market may continue to decline due to a rising interest rate environment with Federal Reserve rate hikes, increasing economic activity, as well as other factors.  For the first time since 2000, offsetting dividend yields with declining bond values will challenge conservative investor with bond portfolios.

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