Intuitively, it would make sense that an actively managed fund would
outperform a passive investment strategy when the market sells off. The
rationale is that 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:
Again, the results are somewhat disappointing, with well less than half the
actively managed funds outperforming their passive benchmark in a period of
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:
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.
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.
Dave Paterson, CFA, is the Director of Research, Investment Funds for
D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due
diligence on a variety of investment products. He is also the publisher
Dave Paterson’s Top Funds Report,
offering regular commentary and in-depth analysis of Canada’s top
investment funds. He uses a unique analytical approach to identify
funds with strong, risk-adjusted returns, and regularly publishes his
insights and analyses in Fund Library.
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