The reputation of active fund managers has been battered since the bull market began in 2009, with years of underperformance prompting ordinary investors to migrate en masse to cheap index-tracking funds.
Stock-pickers say they will prove their worth when the market environment eventually sours, but will they? Do active funds outperform in bear markets, or should investors take such claims with a grain of salt?
While passive funds simply track market indices, active funds try to beat them. They’re failing: nine out of 10 underperformed the US market last year, according to S&P Dow Jones Indices; 81 per cent of global equity funds underperformed benchmark indices over the last decade. The statistics are embarrassing, but managers claim they can make up for this underperformance when the next downturn comes around.
They claim that, while skill may not count for much in a rising market, such periods don't last indefinitely. Active funds can switch to cash or into defensive sectors when the time is right, eliminating the "most egregiously overpriced securities in the index", as GMO strategist James Montier put it recently. Montier's argument was echoed by Oaktree Capital's Howard Marks. Passive funds "don't have the option to refrain from buying a stock just because its overpriced", said Marks. The recent underperformance of active funds may "prove to be cyclical rather than permanent".
Sideways markets
Passive funds are a bad idea not only in bear markets but in sideways markets, Maike Currie argued in a recent Financial Times piece.
“Sideways markets signal a good time to be picking stocks and a miserable time to be locked into a passive fund going nowhere,” she said, saying the flood of money into passive funds and the “lambasting” of active managers had “the makings of a tragedy” for investors.
A sceptic might retort that if we do enter an extended period of low returns, it becomes all the more important that investors keep costs down by plumping for cheap index funds.
Furthermore, whether active funds actually deliver in sideways markets remains an open question – Currie offered no data to buttress her position, simply saying the UK “boasts some of the most skilled stock-pickers in the world”.
However, recent data doesn't support the idea that active funds outperform in range-bound markets. For example, 2015 was a flat year for US stocks, but Morningstar data shows most active funds nevertheless underperformed indices. Similarly, stocks plummeted in early 2016 but came roaring back, resulting in the S&P 500 eking out a small first-quarter gain. Again, funds didn't benefit from this sideways market – only 19 per cent of US large-cap funds beat the S&P 500, the worst quarterly performance since Merrill Lynch began tracking the data in 1998.
Bear markets
What about bear markets? Do active funds outperform when indices head south? Here, the data is mixed. A recently updated Fidelity study found actively-managed large-cap stock funds lost less money than index funds in each of the last three downturns. However, S&P Dow Jones Indices says a majority of active funds underperformed when markets cratered in 2008.
The 2000-2002 bear market was similar, the firm said, concluding pithily: “The belief that bear markets favour active management is a myth.”
Fellow indexer Vanguard is also sceptical. It found a majority of US active funds outperformed in three of the last six bear markets, with European active funds outperforming in only two of the last five downturns. And performance was inconsistent. Typically, an active fund that outperformed in one bear market failed to repeat the trick in the next, said Vanguard, with only 11 per cent of funds outperforming in all six US bear markets.
Fidelity, S&P and Vanguard are not neutral observers – the former is a big player in the active industry, while the latter promote index strategies. What does academic research have to say?
The long-term outperformance of index funds has been documented in countless studies, although research suggests active funds have a better chance of outperforming during bear markets. One 2012 study, Modern Fool's Gold: Alpha in Recessions, found active managers "provide enough value to investors in recessions" to cover their higher expenses, while failing to keep up in other market environments.
In a recent Wall Street Journal piece, Jason Zweig cited research from Wharton Data Research Services which found that, since 1962, the odds of finding an outperforming fund in a falling market are “slightly worse than the flip of a coin”. During the 2000-2002 bear market, Zweig noted, the S&P 500 fell 43.4 per cent; the average fund lost 43.2 per cent. During the global financial crisis, the S&P 500 fell 50.2 per cent; the average US fund fell 49.7 per cent.
Overall, this suggests the relative performance of active funds is better in bear markets than in bull markets, but savings tend to be minor. If you're seeking an active fund that can survive a big market wobble, your best bet seems to be value funds focused on cheap stocks: 80 per cent of large-cap value funds outperformed in 2008 and 65 per cent did so in 2000-2002, according to S&P data. However, as GMO value investor Jeremy Grantham often argues, career risk prevents most fund managers from choosing this path.
Grantham lost 40 per cent of his clients when he refused to buy technology stocks during the late 1990s, and GMO’s cautious stance has resulted in a similarly large exodus during the current cycle. Managers live by the dictum one “must never, ever be wrong on your own”, says Grantham, resulting in most active funds being badly exposed when the good times finally end.
Indeed, this phenomenon appears to be playing out at present. In the first half of 2017, 54 per cent of US active managers outperformed, says Merrill Lynch, meaning they’re on track to deliver their best performance since 2007. They did do by herding into the most popular sectors: funds currently have a record overweight position in technology, widely regarded as the most expensive sector.
Inevitable
Currie argues it “makes sense to pay a professional to roll up their sleeves and do the hard work of finding winners” but it’s a statistical impossibility for all fund managers to outperform each other. Some will outperform, others will underperform, and that’s without accounting for costs. After costs, a majority must underperform over the long run.
It’s also inevitable that their relative performance will be better in bear markets. After all, index funds will always be completely invested in equities, whereas active funds can hold cash. This means if markets drop 20 per cent, a fund with a 5 per cent cash holding should fall by only 19 per cent; if markets rise 20 per cent, this cash proves a drag on performance and the fund rises 19 per cent. This flexibility is an advantage in bear markets, alleviating the burden of higher fees.
One solution for investors seeking some protection from heavy market falls is to stick with index funds while keeping more money in cash or low-risk assets. That way, you combine the low fees of index funds with the flexibility of active funds – a better bet, perhaps, than relying on pressurised stock-pickers to shepherd you to safety.
