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Can Actively Managed Funds Really Beat Index Funds?

02/13/2019

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Unfavorable stock market conditions may create opportunities for actively managed funds to outperform their passive counterparts.
Bear markets are an unavoidable part of the market cycle, and a maturing bull run can induce stress among investors. Rising interest rates and rich equity valuations represent obstacles to sustained stock market growth, necessitating some analysis from anyone with significant assets.
The stock market as a whole is efficient over the long term, but short-term results are subject to downside volatility risk. Investors who recognize the warning signs and adjust exposure can drastically reduce losses to improve long-term results, but market timing is exceptionally difficult for non-professionals.
Passive indexing strategies have performed well during the nine-year bull market going back to 2009. Vanguard’s popular 500 Index Admiral Fund (VFIAX) has produced gross annualized compounding returns of 12.1% over the trailing three years, 11.1% over five years and 14.3% over ten years as of December 2018.
Sustained performance well above historical averages supports the case for passive investing, with many now questioning the value created by active portfolio managers.

Active Funds Outperform Passive Funds in Bear Markets

Morningstar’s research has shown that actively managed U.S. equity mutual funds have outperformed their passive counterparts in falling markets. The data also shows that many of the most successful management teams in bear markets have failed to replicate that outperformance in subsequent downturns. Many investors also doubt that the alpha generated is high enough to overcome the additional expense.

Nonetheless, the data clearly shows that active strategies are able to create value in bear markets.

Professional management teams possess the knowledge and resources to recognize macro trends, analyze valuations and assess overall market sentiment. Passive indexers are at the mercy of the market dynamics during pullbacks and bursting bubbles. The S&P 500 fell 51% in the 2008-2009 crash, having previously lost over 40% of its value from the height of the dot-com bubble in March 2000 to October 2002. The Russell 2000 Index delivered similar returns across those market corrections.

Disinvesting during a market crash can destroy an otherwise sound financial plan. Selling securities that have sharply lost value is effectively “buying high and selling low”, which is the exact opposite of sound investing.

Active managers have the ability to sell equity assets and move into cash when conditions are deteriorating.

A less extreme approach would maintain portfolio exposure to equities, but increase exposure to defensive stocks that tend to retain value and deliver relatively strong operating results during downturns. Fund managers could even look to other markets around the world where valuations or macroeconomic conditions are more favorable.

Opportunity in Volatility

Active portfolio managers create value by identifying mispriced securities. That task is very challenging during steady growth periods with low volatility, because stock price fluctuations are less numerous and less extreme. Investor confidence and macroeconomic trends created precisely such an environment between 2009 and 2018.

Volatility tends to spike during periods of uncertainty, with market participants developing divergent strategies and wider discrepancies among valuations. These are conditions that are favorable for stock picking strategies.

The Benefits of Sophistication

Equities and indexing are intuitive for many people, but a properly allocated portfolio is rarely comprised solely of equities. Bonds are important for volatility reduction, and that becomes even more prominent as investors approach retirement.

Retirees and people approaching retirement cannot withstand major declines in portfolio value, and they often rely on income generated by their holdings to support their lifestyle after earned income ceases to flow.

Active managers create significant value by managing bond portfolios. Effective strategies balance the risks related to inflation, interest rate fluctuations, and default. Ladders, barbells and bullets require a level of sophistication that may not be available to simple indexers.

Other advanced strategies can be especially useful in volatile periods or down markets. The use of options contracts for the purposes of hedging, or loss mitigation, is common among institutional investors. However, retail investors and strictly passive funds are far less likely to embrace such products.

Removing Emotion from Investing

Making investment decisions based on emotion can have devastating effects. Exuberance has led countless investors to chase phantom returns in overheated markets, and irrational fear can lock them out of the returns delivered by attractive valuations.

Professional portfolio managers are not immune to emotional interference, but the most diligent and talented ones exercise patience, conduct analysis, and view allocations in historical context.

Top managers develop a set of principles and rules that is designed to deliver outperformance over the long-term. Adherence to a more academic approach ensures that panic and greed do not influence allocation decisions. Growth depends on future portfolio returns rather than trailing performance.

Retail investors who take a do-it-yourself approach to indexing do not have the benefit of a steady-handed professional guiding their portfolios.

The results are disconcerting, and statistically verifiable. Dalbar publishes an annual quantitative analysis of investor behavior that shows a striking gap between market returns and those realized by the average investor. The deficit is attributed to behavior, and that can be avoided by embracing active management strategies that seek to incrementally improve upon market trends.

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At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

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