I am a firm believer in stock picking. I think stock picking, with the right process and the right temperament, works. Stock pickers, at least the ones I track, in the long run tend to outperform. As a result, the growth in exchange-traded funds, which are investment funds that trade like common stocks and normally “passively” track an index, has been troublesome to me. The number of ETFs listed on the Toronto Stock Exchange has more than doubled since 2011. Pundits forecast these trends to continue, both in terms of asset growth and number of new players entering the marketplace. And the advent of robo-advisors will intensify the shift from active to passive management.

So, is active management doomed? I do not believe so. The more investors use ETFs and robo-advisors, the larger the mispricing of individual securities and the larger the opportunities for active managers—such as value investors—to outperform.

Markets need active investors

If ETFs and robo-advisor companies become popular enough to attract the majority of investable funds out there, they will distort financial markets. Financial assets will be severely mispriced. Such investment vehicles have low costs simply because they forgo the research and trading that active managers carry out. ETFs or robo-advisors do not determine prices. They simply accept what active investors have arrived at after extensive bottom up research on stocks. Who would analyze stocks and determine their fair prices if everyone owned and traded autopilot investments like ETFs or what robo-advisors peddle? Who would mind the shop? If we eliminate active managers, the financial system cannot exist, as someone needs to make prices informative. Berkshire Hathaway’s Charles Munger agrees. As he has put it, “If you pushed indexation to the very logical extreme you would get preposterous results.”

Active management, therefore, will not disappear. Information collection will continue to be valuable.

Closet indexers

And it is not only what is officially indexed that can be a problem, you also have what is unofficially indexed: the closet indexers, which represent an enormous pool of capital. In Canada it’s estimated that about 40% of mutual funds are closet indexers. In the U.S., the figure is much higher. There is going to be a shakeout with many closet indexers exiting the space.

And how about robo-advisors? Are they a threat to active management? And will they survive in their current form? True, computers take the human factor and emotions out of the equation and focus mostly on diversification. But can a diversified portfolio simply run by a committee of robots replicate everything a stock picker can do?

Robo-advisors have no barriers to entry. At the end of the day, most of them will not be profitable and will not be able to stay in business. Banks with superior distribution, trust and brand name will break into the field and eventually wipe many of the smaller players off the map. But robo-advisers will not disappear as banks will be in this business instead of them. TD, in addition to BMO, have already jumped into the robo-advisor market.

Good active managers will also survive and will still make a good living out of active management. There is plenty of evidence for that.

Marcin Kacperczyk, Clemens Sialm and Lu Zheng published two articles in The Journal of Finance in 2005 and 2007, in which they found that the more concentrated a fund was—in other words, the less diversified—the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing. Martijn Cremers and Antti Petajisto, in a 2009 Review of Financial Studies paper, reported that those U.S. funds that deviated significantly from the benchmark portfolio outperformed their benchmarks both before and after expenses.

And in a 2015 study at UCLA titled “Fundamental Analysis Works” co-written by Söhnke Bartram and Mark Grinblatt, the authors show that one can earn risk-adjusted returns of up to 9% a year “with rudimentary analysis of the most commonly reported accounting information.” Such abnormal profits are a result of fundamental analysis and taking advantage of market inefficiencies.

Moreover, humans will need guidance that is provided by a human, especially in an environment of increased volatility in the months and years ahead. A slowdown in economic growth around the world, particularly in China, as well as a slowdown in productivity, lower population growth, aging baby boomers, higher taxes and lower government spending will lead to an increase in stock-market volatility. An expensive market and declining earnings growth in an environment of artificially low interest rates that have encouraged leverage both at the individual and corporate level will also contribute to rising volatility, both realized and expected. In this environment, stock pickers, such as value investors, will shine.

You can read the original article at MoneySense here.