Do active managers really outperform passives in negative markets?

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.

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.

In the bull market from 1998 to 2000 – commonly referred to as the dot-com boom – active managers did relatively well, with 55% outperforming. The bear market of the global financial crisis was another successful period, with 53% 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%, 42% and 43% 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.

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