It’s no secret that active fund managers have been having a rough time lately. The ETF and passive investing revolution have left the mutual fund industry battered and bruised, and the long-term future doesn’t look bright either.

 

This is all comes down to the track record for mutual funds and the fees they charge. The problem is that they have a dismal track record when it comes to outperforming their benchmarks, and they charge higher fees than passive funds. The argument for passive investing is compelling: since an active fund is unlikely to outperform its benchmark, why not just track the benchmark and pay a fraction of the price?

 

That being said, there is a time and a place for everything. And if ever there was a time when active managers had an advantage, this is it.

 

Firstly, equity markets are expensive, particularly in the US. Empirical evidence suggests that it’s unlikely that index returns over the next few years will be anything like they have been over the past eight years.

 

Secondly, funds weighted by market capitalization have a momentum bias. The companies that grow the fastest also have a growing impact on the returns of the index. This works very well during bull markets but has the opposite effect during bear markets. The biggest ETFs in the world track the S&P500, and most of the other indices that large ETFs track follow the same principle.

 

Add to that the fact that the likes of Apple, Amazon, Microsoft, Google and Facebook have a huge impact on performance. That’s great when tech stocks are in favor – but that won’t be forever.

 

Over the past ten years, index funds and products have attracted massive inflows. Between 2005 and 2015, index fund assets ballooned from $868 Billion to $4 Trillion. We have yet to see a correction that causes ETF holders to dump their holdings, but if we do, it’s those mega-cap tech stocks that will see the bulk of the selling. Incidentally, redemptions would also cause a problem for stocks with low liquidity, regardless of size.

 

The above points create an environment that is perfect for discretionary fund managers. It’s a favorable environment for ETFs with an extra layer of filtering – like fundamentally weighted funds.

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Now, this doesn’t necessarily imply it’s time to sell all your ETFs and buy mutual funds. You could do that, or you could just buy shares in the asset management funds themselves. Many of these companies are attractively priced and positioned to do well if or when momentum slows.

 

Affiliated Managers Group (AMG) owns equity in boutique asset managers all over the world.  The company has established itself as a global leader in the active management business. Often, when a manager becomes very big it will struggle to grow its assets under management (AUM), but AMG’s model is focussed on niche operations with room to grow. Despite their subsidiaries managing a hefty $754 Billion, they still grew AUM by 17.4% in 2016. Their market cap is 1.17% of their assets which is cheap compared to many of their peers.

 

Another reasonably valued active manager is UK based OM Asset Management (OMAM), which trades at only 0.71% of AUM. With $240 billion under management, OMAM is smaller and has plenty of room for growth. The forward PE is below 10, despite earning growth of 29% per annum for the past five years.

 

While these are our top picks, other asset managers to consider are Legg Mason (LM), Janus (JNS), and Eaton Vance (EV).

 

There’s another way to play this theme too. JP Morgan (JPM) generates a portion of its profits from asset management. They also generate profits from trading (which can go either way) and investment banking. JPM was a major beneficiary of the Trump Trade, which has now stalled. But if we are moving into a stock picker's market, both active management and trading should benefit.

 

Alternatively, you may want to look at ETFs that don’t have a bias toward momentum.

The ValueShares QVAL ETF, managed by Alpha Architect, uses quantitative screens to filter stocks by quality and value. The fund invests in shares of all sizes, but only those with high-quality earnings. The algorithms used to manage the fund also take investor psychology into account.

 

Another ETF to consider is the Oppenheimer Small Cap Revenue ETF (RWJ). This fund reweights the S&P Small Cap Index by revenue. That means very limited exposure to the stocks that are priced for perfection and more exposure to the stocks with strong cash flows. Again, this isn’t a stock for a massive bull market, but a great fund for those times when investors start looking for quality.

 

If this theme plays out, it could work for anywhere from a year to three years. In the case of a major correction, there would be nowhere to hide, but some of these tickers may still do better than the broad indices. The time to switch back to index funds would be after a correction in the high-flying large cap stocks – whenever that may be.