The year behind us ended well for the US equity market, with S&P 500 Index returns of 14 per cent and fairly low volatility; the biggest drop during the year was a modest 7 per cent, similar to the previous year. US stocks outperformed most bond indices, despite another decline in long-term interest rates, and again outperformed most other stock markets too.

However, an unusually narrow group of managers successfully added value in US Equities, a trend that seems to be encouraging a greater emphasis on passive management for individual and institutional investors alike, and many active managers struggled to stay ahead of the index. The typical index fund outperformed about 80 per cent of active managers in Morningstar’s Large Blend category for example, with even worse results for active managers in the Large Growth and Large Value categories.

Why was 2014 so challenging for so many active managers? It is always problematic to generalise about the results of so many individual portfolio managers and the thousands of decisions that they take, but I would point to three trends probably making life difficult for many of late (listed in my estimated order of importance);

1) The equity market has been fairly narrow; large stocks did relatively well in 2014 and those large cap-benchmarked managers seeking to improve returns by investing in smaller stocks or especially international stocks were unlikely to have benefitted recently. Some have also noted the big contribution to S&P 500 returns from Apple (1.3 per cent added to the S&P 500) and Microsoft (another 0.5 per cent), although it isn’t actually that unusual for big stocks to have this type of impact.

2) Both growth and value investors struggled with a handful of sectors widely regarded as both highly priced and with limited growth prospects, but with relatively high dividend yields. As interest rates surprisingly declined again these dividends were much sought after, with consumer staples returning 15 per cent, utilities 25 per cent and REITs 30 per cent.

3) Although there always seemed to be plenty happening in the markets every day, the fact is that the dispersion of returns between stocks was actually low by past standards, and at times extremely low. So winners were less rewarding than usual, which made it harder than usual for managers to add value net of fees and transaction costs.

None of these appear to be anything more than temporary factors, but the combination of them seemed to have made the market tough to beat for many in 2014.

The question for investors is where does this leave us for 2015 and what’s next? Lower but still reasonably good returns we think, probably accompanied by rising volatility as equity valuations are higher now and the transition to more normal interest rates that surely lies ahead may cause some ripples for equity investors. The key reasons for our positive view are firstly that profits are very strong and likely to rise more before this cycle ends, and secondly the comparison of values between equities and bonds is still very favorable for our asset class.

While our forward expectation for US profits have declined marginally, profits remain exceptionally strong, with margins at records and still rising and until this economic cycle ends, we don’t see that changing; indeed our estimates of normalized earnings haven’t changed much at all in recent months. Strong profits and cash flows should encourage continued stock buybacks, higher dividends and acquisitions too.

As for the active managers in general, many of the trends that made life difficult in 2014 are now well advanced and it is hard to imagine the aggregate performance of active managers being quite as weak again in 2015. But outperforming benchmarks over the long run will never be easy, will always involve periods of weaker results and requires patience and discipline on the part of both the portfolio manager and the client if long term success is to be achieved.