Active vs. Passive in Bear Markets
Does active management earn its fees in down markets…
The other day, I was talking with an advisor, and as it often does, the subject of conversation turned to the equity markets and the current level of valuation. Regardless of the metric, valuations appear to be above historical averages, which increases the likelihood of a market pullback. The question then becomes, when this selloff happens, are you better with an actively managed fund or with a passive index product, like an index fund or an ETF.
Intuitively, it would make sense that an actively managed fund would outperform a passive investment strategy when the market sells off. The rationale is an active manager is better able to navigate the volatility through several available tools, including defensive security selection and carrying higher cash levels.
To study this, I looked at it a couple of different ways. First, I went back through various bear markets on the major indices, and compared the performance of the index with the category average for the period. The results are mixed at best. In Canada, there have been five drops of more than 20% in the index. Of these, active funds outperformed three times, and have underperformed twice. In the U.S., there have been two such selloffs, and the results are split, while for the MSCI EAFE, active mandates have, on average, lagged the index in both bear markets.
The next way I studied this was to see how the active mandates stacked up against the indices in the two most recent down years; 2008 and 2011. In this scenario, I did a very simple analysis and looked at the number of funds that beat the index. The table below shows the results:
| 2011 | 2008 | |
|---|---|---|
| Canadian Equities | 31.90% | 43.40% |
| U.S. Equities | 8.80% | 19.70% |
| International Equities | 22.70% | 20.00% |
| Global Equities | 18.00% | 22.00% |
Again, the results are somewhat disappointing, with well less than half the actively managed funds outperforming their passive benchmark in a period of a drawdown.
A third way I looked at this was to analyze the downside capture ratios of the mutual funds in each category to determine how many funds have shown they preserve capital better than the index in down markets. As a refresher, the down capture ratio calculates how much of the negative performance a fund has experienced over the period reviewed. A down capture ratio of less than 100% means the fund holds up better in down markets, while a reading of more than 100% indicates it loses more than the index in a negative market.
The table below shows the number of funds with down capture ratios of less than 100% in each of the respective categories:
| 3 Yr. | 5 Yr. | 10 Yr. | |
|---|---|---|---|
| Canadian Equities | 58.70% | 69.50% | 54.80% |
| U.S. Equities | 24.20% | 13.60% | 18.70% |
| International Equities | 60.00% | 61.50% | 50.00% |
| Global Equities | 61.80% | 54.50% | 51.10% |
Looking at pure down market returns, active strategies hold up better than the indices, except in the U.S.
If down capture ratios are much better than the index, why don’t the overall returns of active strategies hold up better than the indices in bear markets? The simple answer is most of the funds will lag the index, in some cases substantially coming out of a bear market, so the result is net underperformance for the active strategies.
Bottom Line:
The numbers show that active strategies, on average, lag index strategies in bear markets. This is not surprising, and is consistent with other analysis I have done around active investment management. On average, active funds tend to underperform. But that doesn’t mean active strategies should be avoided. On the contrary, the key is to find high quality, well managed funds that have the potential to deliver above average risk adjusted returns in all market conditions. Active strategies are likely to work better in less efficient markets where managers can exploit inefficiencies for the betterment of the investor.
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