Why actively managed funds don’t outperform in bear markets

There’s a surprisingly durable marketing myth about actively run funds (whose managers try to pick and choose stocks to beat the wider market, rather than just tracking it, as a passive fund does) and bear markets. The myth goes something like this. “Passive funds are all very well during bull markets, when everything goes up. But what happens in a bear market? If you’re in a passive fund, then the value of your portfolio will just drop alongside the wider market. Far better then to be with an active manager, who can take evasive action, move to cash, and exploit the opportunities as they arise.” It’s a compelling argument, logical even. Sadly, an examination of the market data suggests it’s not true.

Take September – we didn’t exactly see a crash, but it was one of the roughest months for equities in a long while, with the S&P 500 US index falling by nearly 5%. Yet as Michelle McGagh notes on Citywire, analysis by Savita Subramanian of Bank of America finds that 58% of large-cap active funds (ie, funds that should be trying to beat the S&P 500) still underperformed the index.

On a longer-term basis, Subramanian points out that this isn’t a fluke. The reality is that “while volatile markets are often perceived as a good environment for active funds”, in fact neither the level of volatility (higher volatility tends to coincide with bear markets), nor its rate of change, makes any significant difference to the number of active funds outperforming.

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It’s not hard to understand why. If you run a large-cap fund with the S&P 500 (or FTSE 100) as your benchmark, then as a manager, career risk is very significant. If you build a portfolio that differs too much from the underlying index, the risk is that you’ll underperform badly and get fired. So there is no incentive to take the goal of beating the market seriously – particularly as forecasting the odd “down” month is almost impossible. Better to hug the index as inconspicuously as possible – you’ll probably underperform, but not badly enough to lose your job.

As Bank of America also highlights, there are certainly strategies that can and do outperform when markets are falling. Hedge-fund strategies tend to do well in volatile markets, but that’s what you’d expect – the flipside is that you often have to put up with relatively mediocre performance in better times. A more interesting finding is that most small-cap funds – where active managers have more scope to find “hidden gems” – have managed to beat their benchmarks this year. In short, if you want to hedge against a bear market, don’t rely on a generic active manager – look for defensive funds. One good example, which is in the MoneyWeek model portfolio, is the Personal Assets Trust (LSE: PNL) investment trust.