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The debate regarding the relative merits of active and passive investment strategies is a well-trodden one. Proponents of active management argue that merely seeking to mimic the performance of an index without performing more in-depth macroeconomic and security-specific research exposes investors to unnecessary risks, and that the higher fees charged by active strategies are justifiable as protection against those risks. Supporters of a passive approach point to the historical difficulty active managers have had outperforming market benchmarks, particularly after accounting for the fee differential.
Our goal here is to evaluate one argument that has gained traction with supporters of active management - that the flexibility inherent in such strategies allows managers to more effectively sidestep problem areas, and therefore offers better protection in down markets than index-based approaches. With many investors expressing concerns around stock market valuation, this argument on behalf of active funds may be of particular interest in the current environment. The two questions we seek to answer are, “Does active actually outperform in down markets?” and perhaps more importantly, “If so, can the average investor benefit from this effect?”
Prior to delving further into the down market thesis, it is helpful to review why the debate between active and passive exists in the first place. On the surface, one might expect an active strategy run by a large team of experienced and talented portfolio managers, analysts, economists, and traders to outperform a “naïve” strategy that merely seeks to copy the market benchmark. That expectation is buffered by the fact that active strategies also cost more, and in most cases when we pay up for something, we expect there to be a comparable increase in the quality of what we receive in return. Unfortunately, this has generally not been the case with active management. Certainly, there have been shorter periods where active strategies have performed relatively well overall, and in virtually any time frame, there are always some active portfolios that perform better than the benchmark. However, over longer time frames, passive strategies have proven stubbornly difficult to beat.
Among the most compelling evidence of the shortfall of active management comes from the SPIVA U.S. Scorecard, an annual performance analysis produced by S&P Dow Jones. The scorecard tracks the short-term and long-term performance of thousands of U.S. stock funds across a full spectrum of 13 distinct style categories.1 To present the fairest comparison possible, the analysis adjusts for so called “survivorship bias” by including results from the large number of active funds that have been shut down or merged during the historical measurement period.
The scorecard highlights the variability that can exist in active performance over short time frames, while underscoring the consistently poor results over longer measurement periods. For example, an impressive 83% of Mid-Cap Growth funds and 86% of Small-Cap Growth funds beat their respective indexes in 2020. Five other categories also saw outperformance, albeit less dramatic, by more than 50% of constituent funds in 2020. In the 20 years of data covered by the scorecard, the number of categories showing average outperformance ranged from 10 out of 13 (in 2009) to zero out of 13 (three times). Though this can hardly be considered a rousing success, it does show at least some potential for short-term excess returns.
Unfortunately for active managers, the evidence beyond a 1-year measurement period becomes progressively more dismal as time increases. Over the 5-year measurement period, only two of the 13 categories generated outperformance by more than 50% of funds, and none did so for the 10 and 20-year periods. The results in many cases were far worse. For example, over the 20-year period, an astounding 96% of Large Cap Growth funds trailed the S&P 500 Growth Index. Incredibly, the best-performing category over the 20-year period was Small-Cap Value, where “only” 76% of funds trailed the benchmark!
Source: S&P Dow Jones Indices LLC
Based on these results and comparable conclusions drawn across many other studies, an investor who wishes to employ a consistent approach over a full market cycle is likely much better off utilizing a passive strategy.
But what about the idea of adding some insurance against a down market by mixing in some active strategies as core holdings or by pivoting between passive and active strategies as the market fluctuates? If the theory of active outperformance in down markets holds, could an investor be better off with one of these approaches?
The most obvious place to start is by evaluating whether active really has delivered downside protection in past sell-offs. Results appear to be mixed at best.
Returning to the SPIVA Scorecard, which has data starting in 2001, we can examine the two most dramatic periods of negative stock performance since the turn of the century – the post-dot com bubble period and the 2008 financial crisis. In 2001 and 2002, the S&P 500 generated returns of -11.9% and -22.1%, respectively. In each of those years, only 4 of the 13 SPIVA equity categories saw outperformance by more than half of active funds in the category. In 2008, a year when the S&P 500 returned -37.0%, the number was only 2 out of 13.
While these results lend little support to the down market hypothesis, a couple of interesting points do jump out. First, of the individual instances of active outperformance during the two bear markets, 80% occurred in one of the “Value” categories. Therefore, there is some evidence that active Value strategies can provide downside protection. Further, active performance did improve in 2003 and 2009, the years immediately after the downturns. In fact, 2009 produced the largest number of outperforming categories of any of the 20 years covered. This may indicate that managers benefitted on a lag from the sharp recovery in the worst performing positions as markets normalized.
Others have also examined the case for active in down markets. Vanguard examined the six bear markets that occurred between 1980 and 2009, concluding that active managers outperformed on average in three of the six.2 Morningstar analyzed rolling 3-year returns for the 20-year period beginning in February 1998 and found that close to 60% of active funds achieved some amount of outperformance during down markets, on average.3 Hartford Funds examined 26 market corrections (corrections include downdrafts of 10% or more that are not large enough to be considered bear markets) and concluded that active outperformed in 15 of 26.4
The variance in results above demonstrate that measuring outperformance is impacted by the peer groups and benchmarks chosen for the comparison, among other things. Additionally, these studies consider returns on a pre-tax basis, which may not align with the outcomes actually experienced by an investor who is subject to taxes. Regardless, the results referenced here and the overall body of evidence do not provide particularly compelling support in either direction. As we discuss below, even if the outperformance of active in down markets is accepted as fact, practical implications likely negate any benefit that the average investor could receive from it.
Many managers of active funds, in a move that seems somewhat akin to throwing in the towel, are now advocating for using a combination of active and passive funds as core holdings. Among their points is that if passive outperforms in up markets and active outperforms in down markets (shaky evidence notwithstanding), a mix of the two will allow the investor to have some outperformers across all market conditions and perhaps a lower level of overall risk. However, this compromise approach is still sub-optimal.
While there have been a number of bear markets in the past and there will be more in the future, the long-term trajectory of stock returns is higher (Exhibit 2). By giving less weight to shorter-term volatility and focusing instead on the smoother longer-term trend of stock returns, investors can see that returns are more frequently positive than negative.
As of 12/31/20
Because passive funds have outperformed active funds on average in rising markets, the strategy of utilizing active funds is similar to “fighting the tide”. So even if the theory of active outperformance in down markets holds, the additional return foregone in the more frequent up markets should overwhelm the improvement in down markets and leave the investor less well-off with a blended portfolio than with a 100% passive portfolio.
The idea of temporarily adding more exposure to active strategies as a hedge against a market downturn may also seem appealing. However, in order for a strategy of pivoting between passive and active to work and offset the long-term return advantage of simply buying and holding passive funds through all market conditions, an investor would have to be consistently able to determine a) when a down market is likely to occur and b) how long the downturn may last. In practice, there has been almost no evidence that investors are adept at timing the market in this way, and in fact, most studies suggest the exact opposite: market timing efforts are not only ineffective, they are largely counterproductive and lead to worse outcomes than a simple buy and hold approach.
Among the most frequently cited cases against market timing is the annual data compiled by Dalbar Inc.5 The study utilizes data on mutual fund performance and investor flows to estimate the realized return earned by the average mutual fund investor as compared to a relevant market index. To the extent investors mis-time their market activity (e.g. pulling money from the market immediately prior to a rally), their realized returns will suffer relative to the index.
The results show that, by poorly timing their entry and exit points, the average stock investor has earned returns that significantly lagged the overall market return. Dalbar attributes much of this shortfall to investors’ behavioral biases, which can lead to irrational decision-making. These include herd behavior, excessive response to recent media coverage, and excessive loss aversion, among others.
Source: Dalbar, Inc. As of 12/31/19
Recent experience demonstrates how investors’ tendency to panic and over-emphasize near-term events can cause sub-optimal timing decisions. According to Morningstar, investors pulled over $250 billion from actively-managed U.S. equity funds during 2020.6 Although market volatility was high due to COVID-19, 2020 was an inopportune time to remove funds from the market, with the S&P 500 returning over 18% for the full calendar year.
The Dalbar study and most other studies of market timing are designed to assess investors’ timing with regard to taking overall market risk rather than their timing with regard to specific switches among different fund strategies. However, there is no reason to believe that the average investor would be any more skilled at timing a switch between active and passive funds than they have been at timing the overall market.
If we choose to ignore the above arguments against mixing active and passive and attempt to integrate active funds into the investment framework, another major hurdle still awaits. Even if we assume that active management has a better chance of success in a downturn, it is fair to say that not all active strategies will achieve that type of success. Since most investors are likely to access active strategies through mutual funds, the investor must also be able to figure out which active funds are likely to outperform. A frequently employed approach is to invest with the active managers or funds that have performed well in the past. The idea is that past outperformance is demonstrative of a manager’s skill, making it more likely that the manager will outperform again. This is an understandable approach, as investors have little more to go on when making active fund choices than past track record.
Unfortunately, this also is most often a misguided approach. Evidence points to the fact that there is little or no persistence in manager outperformance relative to a peer group. In other words, the best managers in a given peer group (e.g. U.S. Large Cap Value) over the last 3 to 5 years are unlikely to repeat that performance in the next 3 to 5 years. In fact, some evidence suggests that managers in the bottom of the peer group are as likely to generate better performance in the future.
In addition to the SPIVA scorecard, S&P Dow Jones also releases a scorecard on the persistence of manager performance. The December 2020 edition analyzed annual performance of over 2,000 U.S. stock funds relative to their peer group. Of the funds in the top quartile (i.e. top 25%) of their peer group in December 2018, only 33.7% remained in the top quartile in each of the following two years. A mere 0.7% of funds in the top quartile as of December 2016 were able to consistently remain there over the following four years. Even staying in the top half is difficult, with only 4.8% able to do so for five years.
Morningstar also analyzed fund performance over various time frames and concluded that “Over the long term, there is no meaningful relationship between past and future fund performance” and that “In most cases, the odds of picking a future long-term winner from the best performing quintile (i.e. top 20%) aren’t materially different than selecting from the bottom quintile”.7 Further, Amundi Asset Management analyzed performance by fund families to see if there were certain platforms that demonstrated consistent outperformance across their funds and found that very few fund families demonstrated persistent skill.8
Specific to the bear market case, Vanguard compared funds’ performance during the dot com bust to their performance during the financial crisis and found a general lack of persistence in the two down markets. Of the funds that performed in the top quintile of their peer group in the post-dot com period, only 23% did so again in the financial crisis. Almost as many of them slid all the way to the bottom quintile.9
Based on the above research, it appears that utilizing past fund performance as a guide for the future is not a winning formula. In fact, we have yet to come across any research or other evidence that contradicts this conclusion.
To continue the logical progression here, let’s assume that an investor still chooses to ignore each of the above arguments. A final practical issue remains to be confronted.
By mixing in active strategies, the investor is now utilizing an approach that will likely be less tax efficient going forward. This is because, in general, active funds have more turnover in portfolio holdings and therefore distribute more in capital gains during an investor’s holding period (for passive funds, more of the pent-up gain is instead realized when the fund itself is eventually sold by the investor). Funds often generate a capital gain distribution even if the market moves downward. This is because the manager may sell holdings that still have a gain associated with them from the prior bull market, adding a further tax penalty to an investor who buys in ahead of the downturn. In fact, according to Morningstar, over 60% of mutual funds paid a capital gain distribution in 2018, a year in which many stock markets posted a loss.
The approach of pivoting between passive and active also subjects the investor to more potential tax liability. Because the passive funds have been held during a rising market and are now being sold ahead of the downturn, there could be a sizeable capital gains tax associated with the switch to active.
For the switch to active to make sense, then, the selected active funds must not only outperform their passive counterparts during the market downturn by enough to justify their higher management fees, but also by enough to offset the potentially higher tax bill.10
A final point is that we are assuming that investors are able to access their desired active funds without paying an up-front sales load or a material commission. If this is not the case, and an investor is subjected to a front-end cost of 1%, 2% or even more, the level of active outperformance that must be achieved in order to justify the switch from passive would be even greater.
Because the general trend in stock market performance over long horizons tends to be positive and because passive funds have been shown to consistently outperform active funds over full market cycles, the path of least resistance is to simply hold passive funds as part of a long-term investment strategy.
The argument that active funds offer downside protection in bear markets may hold some allure. However, evidence that this argument is valid is at best mixed. Further, the practical limitations around implementing a partially active approach further dampen any benefits that could theoretically be achieved.
Even if we take for granted the theory that active funds offer downside protection, in order to outdistance a purely passive approach, an investor would have to be able to:
Based upon the available evidence, achieving even one of the above outcomes on a recurring basis would be highly unusual and display a rare level of foresight, and achieving all three seems nearly impossible.
1. The SPIVA scorecard includes 12 equity buckets spread across Large-Cap, Mid-Cap, Small-Cap, and Multi-Cap. Each of those four broad categories is further divided into Core, Growth and Value sub-categories. The 13th category is Real Estate funds.
2. “Myth: Active Management Performs Better in Bear Markets”, Vanguard, 2018.
3. “Will Active Stock Funds Save Your Bacon in a Downturn?”, Jeffrey Ptak, CFA, Morningstar, February 28, 2018.
4. “The Cyclical Nature of Active and Passive Investing”, Hartford Funds, 2019.
Note, the Hartford study only examined the Morningstar Large Blend category and most of the market corrections lasted for only a few months, so the window of opportunity to benefit from this effect seems limited.
5. Dalbar 2020 QAIB Report.
6. “U.S. Fund Flow Records Fell in 2020”, Morningstar, Tony Thomas, Ph.D. and Suprett Grewal, January 20, 2021.
7. “Performance Persistence Among U.S. Mutual Funds”, Morningstar Manager Research, January 2016.
8. “Persistence and Skill in the Performance of Mutual Fund Families”, Amundi Asset Management (Maurice P. McCourt and Sofia B. Ramos), March 2019.
9. “Myth: Active Management Performs Better in Bear Markets”, Vanguard, 2018.
10. This tax impact would be mitigated for investors who utilize tax-advantaged accounts to implement the strategy. However, investors who utilize an employer-sponsored retirement vehicle such as a 401(k) plan are limited to just the active funds made available through that plan, which decreases the likelihood of finding the exact funds that will outperform.
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