Featured Wealth Management Article
When the Financial Markets Get Turbulent, We Need Active Management and Hedge Funds to Save Us, Right?
by Robert M. Cheney, CFA, CFP® Dated 3/09/20
So there I was, at a recent conference hosted by a passive investment management firm. During a break at the coffee bar, I overheard another financial advisor explain to his colleague “I buy that passive management will outperform in a bull market, but what about market corrections and bear markets? That’s when active managers really shine.” I immediately put my palm to my forehead and felt the need to correct his assertion. Let’s review what the data shows.
First, an explanation of passive and active investing. Passive investment managers remain fully invested during all market conditions and do not try to time the stock market or pick and choose individual stocks; they simply attempt to match equity market index returns. Active investment managers such as active mutual funds and hedge funds, by contrast, attempt to time the stock market, picking and choosing individual stocks in an attempt to beat equity market index returns.
Over the past decade, investors have embraced passive investment management in the forms of index and asset class mutual funds and exchange traded funds (ETFs) because their fees are significantly lower and performance has been better, on average, than active mutual funds. S&P Dow Jones Indices has published its S&P Indexes Versus Active (SPIVA) Scorecard since 2001. The most recent calendar year SPIVA Scorecard available, for 2018, concluded, “Over the long-term investment horizon, such as 10 or 15 years, 80% or more of active managers across all categories underperformed their respective benchmarks.” Still, as the case for active management has steadily retreated, with more and more money invested passively, some active managers and their dwindling number of promoters have made a last stand around bear markets.1
They claim that active managers have a distinct advantage when markets decline, by getting out of troubled stocks and sectors early and avoiding the worst of a downturn. In theory, this seems reasonable. The problem is that the evidence just isn’t there in practice.
S&P’s May 2009 Index Versus Active Funds Study focused on the terrible “Financial Crisis” bear market of 2008 and concluded, “the belief that bear markets favor active management is a myth.” In aggregate in 2008, actively managed funds underperformed the S&P 500 Index by an average of 1.62%. In this same study, S&P identified similar results for the 2000 to 2002 “Dot.com Bust” bear market. In both that bear market and the one in 2008, the majority of active management funds underperformed their respective S&P Index benchmark for all US and international stock asset classes.2
“What about hedge funds, don’t they have smart people?” some of my clients ask. Hedge funds are another form of active management where managers have even more leeway to pursue a range of strategies such as betting against particular stocks or sectors and thus claiming that their funds can profit in rising, flat, or even declining stock markets. As a whole, hedge funds experienced lower losses than the S&P 500 in the one-year period of the 2008 bear market. A few were even able to post gains in that environment, such as the funds detailed in the movie and book, The Big Short, by Michael Lewis, and this helped them gain attention. However, for the 10-year period ending 2017 (a period that included the 2008 Financial Crisis bear market), hedge funds finished with a -0.4% annualized return loss according to the HFRX Global Hedge Fund Index, underperforming every single major equity and bond asset class over the same period. For reference, the S&P 500 gained 8.3% annualized over this same 10-year period.3
One of the greatest challenges for any active manager of a mutual fund or hedge fund is the extreme difficulty in forecasting the economy and accurately predicting the market’s direction in advance. To anticipate the stock market direction, active managers need to be right twice; they need to predict trends in the economy and they need to predict human behavioral reactions reflected in the stock market. Wall Street has exhibited a poor track record of predicting either one.
So what can we do in the event of a correction or bear market? Among Type A people, we particularly feel the need to take action and not just sit there… However, we can only control those variables that are within our control. Market performance is not one of those variables within our control so it may be wise to not pay too close attention to it. First priority is to remain dedicated to a long-term investment plan developed by both you and your advisor. Work with your advisor to confirm that your risk assumed is indeed appropriate to your risk appetite. Make sure that your actions and attitudes during a correction or bear market are those that were prepared with your advisor before times got tough. Revisit your financial plan. If your financial plan demonstrates that at no time will you need to liquidate more than a small portion of your investment portfolio, then it is likely that a time with significant volatility swings or when the investing public is panicky is not a wise time to think of liquidating a majority of the portfolio. Maximize tax efficiency and evaluate opportunities to “harvest” tax losses in taxable accounts. Look for opportunities to rebalance and buy back in to stocks at lower prices.
By avoiding investment approaches that have not demonstrated a track record of adding value for investors, we keep our investment and financial plans from getting off-track. A sensible investment management approach teamed with a comprehensive, data-driven advisor can be invaluable in keeping investors on track to reaching their financial objectives.
1 Source: S&P Dow Jones Indices, “SPIVA US Scorecard 2018”
2 Source: S&P Dow Jones Indices, “Standard and Poor’s Indices Versus Active Funds Scorecard, Year End 2008”
3 Source: Loring Ward Advisor Insights Blog, “2018 Report Card for Hedge Funds”