The current environment is most suitable for stock pickers. Those who thrive off volatility are most likely to succeed.
When most stocks are trending upwards, exchange traded funds (ETFs) can be an appealing investment vehicle. In a single trade, investors gain exposure to a basket of stocks that don't require individual monitoring.
This strategy has served investors well over the past five years. In fact, several low-cost popular ETFs are delivering double-digit returns. For example, in the five years prior to 30 April, the Vanguard US Total Market Shares Index AUD ETF (ASX: VTS) increased at a compound annual growth rate (CAGR) of 15.56%. Those invested in the Vanguard Australian Shares Index ETF (ASX: VAS) also did well for themselves, achieving a 12.08% CAGR over the same period.
But these ETFs have underwhelmed for the year to date. The VTS ETF is down 5%, while the VAS ETF has risen around 3%. However, it's worth noting that the journey has not been linear, with significant volatility along the way.
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A widening gap between the winners and losers
It's true that volatility creates opportunity. Temporarily lower share prices give investors a chance to buy their favourite stocks on sale. The same applies to ASX ETFs. Those who bought the VTS ETF and the VAS ETF during the April low point have already made a 13% and 14% return, respectively.
However, there is greater potential for stock pickers to generate massive returns under these conditions. For example, Pro Medicus (ASX: PME) is up around 55% since its April low. Meanwhile, Boss Energy Ltd (ASX: BOE) is 90% higher.
While it is always true (by nature) that stock picking can outperform the overall market, the gap between the winners and losers has widened. For example, within the travel sector, Qantas Ltd (ASX: QAN) has outperformed Flight Centre Travel Group Ltd (ASX: FLT) by more than 100% over the past 12 months.
Volatility is being driven by sentiment surrounding US President Trump's ongoing tariff plans and a potential recession. Moody's downgrading US debt, ongoing geopolitical conflict, and rising bond yields have also triggered sell-offs. With these issues unlikely to resolve anytime soon, volatility is likely to continue, making it a stock picker's market.
Valuations matter
Another factor that favours stock picking is the valuations of the overall market.
The current price-to-earnings ratio (PE) of the S&P 500 Index is approximately 24 times. This is substantially above the historical median, which sits at 18 times. Meanwhile, the current P/E ratio of the S&PASX 200 Index (ASX: XJO) is approximately 19 times. This also sits well above its historical median of 15 times.
Accordingly, forward returns for the overall ASX and US markets are not compelling. Investing in ASX ETFs that replicate these benchmarks, such as the iShares S&P 500 AUD ETF (ASX: IVV) or the BetaShares Australia 200 ETF (ASX: A200) today may be an underwhelming endeavour.
To beat the market, investors should seek out high-quality businesses that are attractively valued. While, on average, equity markets are expensive, there are still compelling opportunities to be found. For example, Medibank Private Ltd (ASX: MPL), APA Group (ASX: APA), and Metcash Ltd (ASX: MTS) are all trading at attractive valuations.
Foolish Takeaway
Many investors may be disappointed by their own returns for the year to date. Despite substantial volatility, many investments are roughly flat for the year. With equity markets likely to remain volatile for the remainder of 2025, and valuations sitting above their long-term medians, savvy stock pickers have the opportunity to beat the market by a substantial margin.
