A frequently trotted out justification for paying expensive fees for actively managed funds is that active managers come to the fore during bear markets. It’s too much (it seems) to expect them to keep up with indices during stockmarket rallies and volatile market periods. But when a downturn comes, while passive funds plunge with the underlying market, active managers can offer some security, upping their cash reserves and moving into more defensive positions. That’s when you’ll be thankful you handed all that money to your beaming fund manager, as your passive-investor friends tear their hair out. Or so the story goes.
But as with many tales told to justify paying active fees, it’s simply not true, as new research from Morningstar, based on performance during the recent downturn, reminds us. John Rekenthaler compared the returns of US actively managed funds (large-, mid- and small-cap) from May 2015 to 15 January 2016 to that of the relevant Russell (US stockmarket) index. For each size of fund, he looked at three categories: growth, value and “blend” (a hybrid of the two).
When looking at large- and mid-cap funds, active funds lagged the index in all three categories. Among large-caps, growth funds fared the worst, with only 23% outperforming the Russell 1000 Growth index. For mid-caps, roughly a third of active funds beat the indices. Small-cap funds showed the most promise (by which we mean they were “the least worst”). Active funds in all three categories beat the index more than half the time (ranging from 53% to 61%). “It wasn’t a resounding success by any means, but… small-company funds offered at least a hint of an umbrella,” says Rekenthaler.
Rekenthaler himself admits that “this hasn’t been a full test of active funds’ downside protection” – even the worst of the nine Russell categories (small-cap growth stocks) haven’t quite fallen by the 20% that constitutes a bear market (yet). But this research only confirms a swathe of past data. “The belief that bear markets favour active management is a myth,” argues credit ratings group Standard & Poor’s.
Over the five years from 2004 to 2008, 72% of actively managed large-cap funds underperformed the S&P 500; the results were similar from 1999 to 2003 (both periods included significant bear markets). “In the longest downturns, defined as declines of five consecutive months or longer, index funds outperformed actively managed funds 100% of the time,” reports financial adviser Vista Capital, quoting research by Schwab, which analysed market declines between December 1986 and March 2001.
It’s no secret that at MoneyWeek we tend to favour passive investing. You can’t predict when a bear market will strike (if you could, you’d move to 100% cash, rather than try to find the active manager who’d lose you the least money), but you can control how much you waste on fees when you invest. But if you’re looking for decent bear-market funds, there are a few that have proved their mettle.
As Natalie Stanton noted a few weeks ago, any of Ruffer Total Return, Troy Trojan or Personal Assets Trust (which is in our model investment trust portfolio) would make good conservative additions to a portfolio.