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Do active managers really outperform passives in negative markets?

Vanguard chief economist for Europe Peter Westaway

As index investing has become more popular, so the focus on it has increased. An argument to have gained prevalence recently is that index funds will tend to underperform active managers in strongly positive and strongly negative markets. However, when we look at the long-term performance data, we find that this doesn’t hold water.

The argument is based on the premise that active managers can position their portfolios to benefit from the prevailing conditions. For example, they could buy higher-beta stocks during a bull market or move into more defensive sectors or cash during a bear market.

The reality is that markets are a zero-sum game. The index is the average of all the investments in a given market and, for every pound that outperforms the average, there is another pound that underperforms. At first glance, this appears to give us a 50 per cent chance of success.

However, that’s before costs. After costs, more than half of the invested pounds lag the average, or the index. And, because active funds tend to have higher charges than passive funds, they have to clear a higher hurdle before they add value.

Timing is everything

On top of the zero-sum game argument, we have the extreme difficulty of timing markets. Changes in market direction tend to happen quickly and with little warning. To add value, active managers need to anticipate change, draw the right conclusions about future performance, and implement their views at a cost that doesn’t outweigh the benefits. And then they need to repeat that process on the way out of their positions.

The data show that few managers manage to do this consistently. We examined the three bull markets and two bear markets that investors have experienced since 1998 and measured the performance of active managers relative to their prospectus benchmarks in each period. The following chart shows the results:

In the bull market from 1998 to 2000 – commonly referred to as the dot-com boom – active managers did relatively well, with 55 per cent outperforming. The bear market of the global financial crisis was another successful period, with 53 per cent of active managers outperforming. However, in the other three periods – the dot-com bust, the bull market from 2003 to 2007 and the bull market that has followed the financial crisis, the results were significantly worse. In these periods just 40 per cent, 42 per cent and 43 per cent respectively outperformed.

So there is no evidence of active managers systematically adding value in either bull or bear market conditions. It’s also worth remembering that, irrespective of market conditions, active management will give investors a wider spread of outcomes. Sometimes they will significantly outperform, sometimes they will be in line with the index and sometimes they will significantly underperform.

Staying on the rails

That’s one reason why we say that most investors are likely to be well-served by a passive approach for the core of their portfolio. They might get a positive return or a negative return, but that return should always be close to what the market produces.

Narrowing the range of outcomes around the market return means that you, the adviser, shouldn’t have to explain unpredictable out- or underperformance. Instead, you can focus on adding value through things that you can control, such as long-term asset allocation, controlling cost and helping your clients to avoid the pitfalls of behavioural bias.

Having read this far, you might think that I am anti-active. Far from it. At Vanguard we believe that active funds can play an important role for some investors. But in all market conditions, active investors need to identify talented managers, access them at low cost to maximise their chances of success, and have the patience to see out inevitable periods of underperformance.

Peter Westaway is chief economist for Europe at Vanguard Asset Management

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Comments

There are 4 comments at the moment, we would love to hear your opinion too.

  1. Nobody has ever claimed that ALL active funds outperform passive funds. Even at the lowest findings 40% of active funds DO outperform the index. Value for money varies across all private goods, why would investment funds differ?

    • Unlike your other purchases, what you pay for your investment is ultimately deducted from its ‘value.’ There is no foregone conclusion why a 3%, 4%, or 5% product fee should return incrementally higher performance. In fact It is quite the opposite. The gross and net return drift further apart. Basic laws of arithmetic apply here.

  2. These passive acolytes really do bang on without much to back them up. As Mark W has said, of course not all fund managers outperform and those that do often don’t do it consistently – although some indeed do.

    It’s like motor racing between 1974-98 McLaren won 8 constructors titles and today they are nowhere. Williams won the constructors title 9 times from 1980-97 and now they are second quartile.

    Ferrari have been the long term consistent champions with 16 constructors titles. If you want consistency of drivers (fund manager equivalent) then you have to go for Fangio and Schumacher.

    And so it is with active funds. It is the job of the adviser to spot the good ‘uns and avoid the lemons. No less for passives. A Japanese tracker has had its ups and downs and a decent adviser would have avoided the poor years as far as possible.

    As I have said before passives appeal to many advisers as it helps to ameliorate their high fees and for others it hides their poor grasp of investment technicalities.

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