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By: Sam Instone

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May 24th, 2017

Active or passive: which is best when markets plummet?

Investment

[Estimated time to read: 5 minutes]

By historical standards, stock markets have been on a very good run.

The bull market, which began in March 2009, is more than eight years old.

No one knows when it will end, but it will.

Forecasters, stock pickers, fund managers and salespeople say this is when their more expensive funds will have their days. 

which is best when markets plummet sm.jpg

After all, a manager can just switch his holdings to cash.

So, when we have a correction or crash, will you be better off in actively managed funds or passively managed ones?

When the going gets tough…

Whatever type of fund you use, it’s critical to ensure you aren’t taking any more risk than you can afford to, or than you feel comfortable with.

Geographical Regions

Diversification across different asset classes and geographical regions is hugely important – this is often what DIY and amateur investors get wrong.

The other thing to understand is that the active versus passive debate isn’t about risk, or risk management, at all — keen though the fund industry is to give people that impression.

"Indeed, one of the most insidious myths that the industry likes to perpetuate is that active funds are better than passives in bear markets".

Index funds, we keep being told, fall with the markets – whereas active funds provide the reassurance of “downside protection.”

(Jargon definition: downside protection = the use of an option or other hedging instrument to limit or reduce losses.)

Let’s face it, downside protection sounds great!

What’s not to like about a fund that offers the potential of outperformance when markets are on the up, with the reassurance of limiting your losses on the way down?  

This little myth is a salesperson’s dream!

Understanding risk

The problem is that it’s impossible to design a portfolio that provides market-beating performance at low risk.

Investors are compensated for the risk they take.

If you want higher returns you must accept greater risk.  There has to be a trade-off.

High returns with low risk is like having your cake, and eating it.

There is a very simple reason why active funds sometimes outperform index funds in bear markets.

With equity index funds, you know what you’re getting — 100% equities.

Passive Active Tortoise

Most active funds on the other hand, hold a small amount in cash, and sometimes in bonds as well; this gives them an advantage when markets are falling (and a disadvantage when they rise).

It’s this ability to run for safety which proponents of active investing claim gives active managers an edge in bear markets.

But there are two important issues they conveniently overlook.

First, the exposure of active funds to safer assets is still pretty minor.

As Jack Bogle has said:

“A 5 to 10% tail of cash cannot possibly wag the dog represented by a 90 to 95% equity position”.

Second, as Morningstar has shown, active funds generally hold equity portfolios that are riskier than the portfolios of major indexes, which tend to be dominated by higher-quality, larger-cap stocks.

These two factors help to explain why, contrary to the conventional wisdom, managed funds generally do worse in market downturns than index funds!

Active v passive in a falling market?  Let’s look at the evidence!

Looking at the evidence – here are some examples from the US:

  1. In the correction of mid-1990, the S&P500 fell 14.7%, but the average actively managed fund fell 17.9%
  1. In the bear market of the summer of 1998, the S&P500 dropped 19%, compared to 22.2% for the average managed fund
  1. In its 2008 Indices Versus Active (SPIVA) scorecard, Standard & Poor’s concluded:

“The belief that bear markets favour active management is a myth.

A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008.

The bear market of 2000 to 2002 showed similar outcomes.”

Stock Index 2008

To be fair to active managers, there is some evidence to show that some active strategies have performed marginally better in recessions.

But even if you take the best-performing funds during the most successful five-year period for active managers in recent times — the period ending September 2002 — close examination of the data reveals a rather different picture.

Vanguard found that fewer than a third of managers were able to repeat their out performance in the following five-year period!

Furthermore, fewer than 45% outperformed their benchmarks in the bear market of 2007-2009.

Both results fell far short of the 50% outcome you’d expect from random chance.

In other words, even the top-performing managers fail to repeat any skill they showed in one bear market during subsequent bear markets.

Don’t forget to factor in cost

Yes, there will be funds that outperform in the next bear market — whenever that might be — but your chances of picking those funds in advance are worse than flipping a coin.

Ultimately, it boils down to cost.

As the Nobel-winning economist Professor William Sharpe pointed out in his paper The Arithmetic of Active Management, the average passive investor must — yes, must — outperform the average active investor, because of the considerable additional costs that active investing entails.

The cost of using the active funds that most banks and financial salespeople recommend will put a huge drag on your investment performance, which any fund manager would struggle to overcome through stock selection or market timing.

And in conclusion:

The lesson is simple: stick to low-cost index funds regardless of the market conditions and follow the 5 other simple rules of investment here.

If you want downside protection — and are willing to forgo a portion of your expected returns to have it — then hold a cash or bond reserve yourself, and save yourself a fortune in fund managers’ fees.

Finally, if you want to read more about the active v passive debate – here’s a free eBook for you.

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About Sam Instone

Sam Instone, CEO at AES International, is passionate about positive change and ensuring expat investors get the best results.

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