Active money managers want you to believe that they can act defensively to mitigate the downside of stocks during a market downturn. This is one of the ways that active managers may try convince you that index funds are too risky. No investor likes the idea of passively sitting by while their portfolio falls with the market.
Investing in index funds means accepting the market through good times and bad, but active managers claim that there is a better way. Should you listen to them?
An index fund will continue to own all of the stocks in the index regardless of the external environment, meaning that when stocks are falling in value, you will continue to own them, and your portfolio will fall in value. An active manager will claim that they can reduce your losses by making changes to the portfolio.
Remember that investing is a zero sum game. If one active manager is able to beat the market during a downturn, it means that another active manager is underperforming. This simple rule invalidates the claim that active managers will always be able to protect you when the market is falling.
Most actively managed funds underperform the market over the long-term, but active managers claim that in anticipation of a downturn they might sell some of the stocks in your portfolio to insulate you from the expected losses. You can always find active managers prognosticating the next market crash, and explaining what they are doing to prepare for it. Maybe they are holding cash, or only buying certain types of stocks.
If you can find an active manager that can offer protection in bad markets, that would truly be an advantage. The problem is that there is no evidence of the ability of active managers accomplish this consistently. During the 2008 US market downturn, 60% of actively managed US equity funds in the US outperformed the market. In the 1994 European bear market, 66% of funds were able to beat their benchmark. That seems promising. Better than a coin flip, anyway.
As promising as that may seem, a 2008 white paper from Vanguard looked at active manager performance during bear markets between 1973 and 2003. Of the 11 bear markets examined, there were only 5 instances where more than 50% of active managers outperformed. There is no evidence that active managers, on average, have been able to produce better performance than index funds in down markets.
Vanguard’s research did not stop there. The paper goes on to examine what happened to the funds that were able to outperform during bear markets in subsequent bear markets. The results showed that outperformance in one bear market had no statistical relationship to outperformance in other bear markets. This is an indication that the funds that did outperform were merely lucky as opposed to skilled. This result was corroborated in a 2009 paper by Eugene Fama and Ken French titled Luck vs. Skill in the Cross Section of Mutual Fund Returns. They found that, on average, U.S. equity mutual funds do not demonstrate evidence of manager skill.
More recent research, again from Vanguard, examined the performance of flexible allocation funds in bull and bear markets between 1997 and 2016. Flexible allocation funds are able to change their allocations at will to try and time the market. During that period there were three bull markets and two bear markets. During bull markets, only between 31 and 36 percent of the funds were able to beat their benchmarks. The numbers were better in bear markets, with 65% of funds beating their benchmark in the 2000 to 2003 downturn, and 45% of funds beating their benchmark in the 2007 to 2008 downturn.
While active fund performance is generally very poor on average, it appears to be slightly less poor during bear markets in this sample. The cost of active management is a heavy cost to carry for what might be a slightly greater chance at outperformance during bear markets. In the 10 years ending June 2017, only 8.89% of Canadian mutual funds investing in Canadian stocks were able to beat their benchmark index, and only 2.54% of Canadian mutual funds that invest in US stocks were able to beat their benchmark index.