Do active funds do better in bear markets? Nope

Active funds won’t shelter you from financial storms any better than tracker funds will

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Do active funds do better in bear markets? Nope

Every time I write something about how cheap "passive" funds (which track an index or asset price) are a better bet than the majority of expensive "active" funds (which try to beat the market, but mostly don't), there's always a queue of people with "ah buts".

One classic goes something like this: "Ah, but while passive funds do OK when the market is rising, active funds really come into their own in a bear market".

It's the kind of thing you hear from managers who can't dispute the overwhelming evidence of underperformance by active funds, but think they've found a convincing-sounding loophole.

And it does sound convincing.

So it's a shame that it's utter balderdash...

Let's dispense with a couple of myths about active management

2016 got off to a scary start for most investors. In fact, it was one of the worst starts to a year on record.

Now, to be fair, it all turned around come March. The Federal Reserve gave the stockmarket a little pat on the head, stroked its ears, and set its little furry tail wagging again.

By the end of March, the S&P 500 had recovered all its losses, and ended up gaining 0.8% over the quarter.

Still, all that turmoil must have provided the perfect opportunity for active managers to show their mettle, wouldn't you say? To demonstrate that stock-picking prowess, that astute selectivity that only an expert human eye can possess. No dumb trackers here. These are market conditions to separate the men from the boys.

So how did they do?

Worst quarterly performance ever.

Just 19% of US mutual funds that invest in large-cap stocks beat the S&P 500 (the US benchmark index) over the quarter to the end of March.

Now let's be fair here. The Bank of America Merrill Lynch data only goes back to 1998, reports the Financial Times. So when I say "ever", we're only talking 18 years here. It's not eternity.

Still, if you'd stuck your money in the average active fund in that sector over this time, you'd have underperformed the market by 1.9 percentage points (also a record lag, by the way). In other words, while the market was roughly flat, you'd be down on the year.

I can already hear another objection.

"Ah but, you see, that's the S&P 500, the most efficient stock market in the world. You can't expect active managers to beat that sort of market. There are so many analysts covering it – I mean, sure go passive in that kind of market".

(No one ever points out the obvious here by the way – if popular investment wisdom dictates that no one can beat the US large-cap market, then why the blazes are there any large-cap, US-focused active funds? Isn't the fact that they even exist something of a mis-selling scandal?)

Anyway, back to the "ah but".

"Other markets are less efficient. You've got the opportunity for stock pickers to add value. A tracker can't give you that edge".

Fair enough. That sounds convincing. And handily enough, BoAML have got figures on other investment styles too. Presumably they'll show better results, what with all that inefficiency and the rest of it.

Let's see. Here's Robin Wigglesworth in the FT again. "The "beat rate" – the ability to outperform the market – was even worse for growth funds, which target typically smaller, younger and more rapidly expanding companies."

Hmm. Doesn't sound good.

And it isn't. Just 6% of growth funds beat their benchmark. Those results are the worst since 1991, apparently. And the average fund underperformed by a whopping 3.5 percentage points.

Value funds did badly too – just under 20% beat their benchmark. And guess what. All of these figures are before fees. So you can lop off another percentage point or so from those numbers too.

In short, pretty much regardless of strategy, if you could have found a cheap tracker to pursue it, you'd have been better off in most cases than if you'd bought the active fund.

If you're planning to buy a unit trust, just pause for a minute

I'm not saying – and I never have said – that all active funds are bad, or that no active fund manager can ever beat the market. That's patently not true, and in the investment trust world, the proportion of outperformance is a lot higher (which is why we tend to favour them at MoneyWeek – subscribers can check out our model portfolio here).

But there are a whole lot of myths that the industry keeps promoting – about active funds routinely doing better in "inefficient" markets, or being a better option in bear markets – that are just patently false.

Here's what this means for you as an investor, just to be clear. You find a market you want to invest in – Japan, small caps, gold miners, whatever. You look at the options available to you. In the vast, vast majority of cases, unless you do some serious homework, then you are going to be better off choosing the tracker option, or – if it's a more obscure market, or a high-conviction strategy – the investment trust option.

If you're thinking of shelling out for a unit trust/OEIC, then at the very least pause for a minute, and make sure that you have made the case to yourself very clearly before you do so.

As I've mentioned before, if you're interested in a cheap, easy-to-run investment portfolio that uses passive funds then you should check out our Lifetime Wealth strategy.

But more to the point, even if you don't care about that, before you invest in anything, make sure you're getting value for money. It's just common sense.

For example, if you want to invest in the S&P 500 then you really need to see some serious proof that an active manager is worth the extra dough compared to a passive exchange-traded fund or tracker that will charge you no more than a few basis points (a basis point is 0.01%) for the market return.

Anyway – hopefully more and more investors are getting the message. The growing volumes of money going into the passive industry suggests so. Long may it continue.

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