Active Versus Passive in a Down Market

The Wall Street Journal has been publishing articles about passive investing recently.  Many of these articles look like they are pro-passive, but are written by active management shops looking to damn passive with faint praise.  My last post addressed the ‘settle for average returns’ fallacy.  The second argument I often see in support of active management is that it outperforms in down markets.

I’m not sold on the data behind this assertion, but let’s assume it’s true and active managers outperform during down markets.  Maybe they aren’t completely invested and hold cash or maybe they just pick the stocks that don’t go down as much.  Whatever the secret, CONGRATULATIONS!  YOU BEAT THE MARKET DURING DOWNTURNS!!!

Now you just need to know when the next downturn starts and ends so you can go active at the right time.  That’s where the argument starts to break down.  It’s difficult/impossible to predict what the market will do.  There’s a reason people say that economists exist to make meteorologists look good.  Since the financial crisis, we’ve been beaten over the head with predictions of a NEW NORMAL with returns in the mid-single digits, if we’re lucky.  Instead, we’ve gotten double digit returns while the markets climbed a wall of worry.  Pundits continue to predict low returns and eventually they will be right, but don’t confuse the fact that a stopped clock is right twice a day with someone who can predict the market’s returns.

On top of the fact that it is foolhardy to try to time the market, downturns just aren’t that common.  The market goes up about 75% of the time.  Dr. David Kelly of JP Morgan likes to say that the market is like Florida – long summers and short winters.  Even if you could time the market and active outperforms passive in downturns, you’d only be able to take advantage of this about 25% of the time.

It is also worth mentioning that in a downturn, every drop of return is precious.  However, actively managed funds tend to be more expensive and less tax-aware than their passive counterparts.  This means even less money stays in the pockets of investors.

Lastly, it pays to take a step back and look at the entire picture when thinking about investing.  Besides equities, a prudent investor would also have bonds and real estate which are not correlated with equities in their portfolio.  The role of these assets is to buoy the portfolio when equities lag.  Paying a fee to a manager who doesn’t fully participate in his assigned asset class doesn’t make sense.  If an investor needs to adjust a portfolio’s exposure to equities, it should be done at the asset class level.  A mutual fund manager doesn’t know the investor’s risk tolerance and goals.

In my next post, I’ll cover the argument that investors will outperform if they just buy the ‘good’ active managers.