It’s been well documented that, on average, actively managed funds underperform their appropriate risk-adjusted benchmarks after accounting for expenses. There’s also little to no evidence demonstrating that the few active managers who do succeed in one period are able to show persistent outperformance in the next. The lack of persistence makes it difficult, if not impossible, to identify the few future winners ahead of time.
Looking at the Research
An interesting question is whether or not investors would be willing to accept underperformance, on average, if the active managers outperformed during recessions, when labor capital is most at risk. In other words, perhaps investors would be willing to pay high fees for alpha that is generated during recessions. Christopher Fink, Katharina Raatz and Florian Weigert—authors of the September 2014 study, Do Mutual Funds Outperform During Recessions? International (Counter-) Evidence to determine if actively managed funds do outperform in such periods.
To find the answer, the authors used a worldwide dataset of equity mutual funds covering 16 different countries and the period from 1980 to 2010. To determine whether a country is in a recession, they used recession indicators from the National Bureau of Economic Research (NBER) for the United States and recession indicators from the Economic Cycle Research Institute (ECRI) for the 15 remaining countries. The following is a summary of their findings:
Despite the advantage of being able to shift allocations from stocks to bonds, actively managed funds underperformed in 15 of the 16 countries, with the underperformance being statistically significant at the 1 percent level. The sole exception was Germany, where active managers showed a small and statistically insignificant level of outperformance.
Based on the authors’ worldwide sample, mutual funds underperform during times of recessions by -0.4 percent per month based on the Carhart four-factor model (beta, size, value and momentum).
The results were the same when computing fund alphas on alternative asset pricing risk factors or using alternative business cycle measures of recession. It also made no difference when looking at global versus local recessions — the underperformance persisted.
All fund styles displayed negative recession performance. The worst performance was from the income fund style (-0.52 percent per month), followed by the large-cap (-0.51 percent per month) and mid-cap (-0.40 percent per month) fund styles.
There wasn’t a positive relationship between mutual fund performance in recessions and a fund’s fee structure. In fact, the mutual funds in the quintile with the highest recession performance had total fund fees 0.08 percentage points lower than funds in the quintile with the lowest recession performance.
An interesting finding was that fund tracking error increased during recessions, indicating that fund managers became more active during such periods. Yet, there was no evidence that the extra activity was productive. In fact, the authors found that during times of economic downturn, funds with high tracking error underperform funds with low tracking error — another indication that the additional activity was indeed unproductive.
Another intriguing result from the study was that countries with less developed capital markets and less developed fund markets experienced worse performance in recessions. This runs contrary to the idea that active managers have the advantage in so-called less efficient markets. A likely explanation is that any informational advantage they might gain is more than offset by the higher transactions costs generally incurred in less developed capital markets.
The authors also examined the recession performance of hedge funds, using data from the TASS database, for the period from 1994 to 2012. To control for specific hedge fund risk factors, they used the seven-factor model proposed by William Fung and David Hsieh in their 2004 paper, Hedge Fund Benchmarks: A Risk Based Approach. As was the case with mutual funds, they found compelling evidence that, on average, hedge funds underperform during recessions. They also found that this was true across the majority of hedge fund investment styles.
The authors concluded that there was strong evidence of underperformance during recessions for both actively managed mutual funds and hedge funds. This finding shouldn’t really be a surprise. William Sharpe — in his 1991 paper, The Arithmetic of Active Management — demonstrated that, in aggregate, active managers must underperform, regardless of their asset class or economic cycle, simply because they have higher expenses. That’s what John Bogle called the Costs Matters Hypothesis. Sharpe explained: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
While active managers haven’t outperformed in recessions, is it possible — because the timing of recessions and bear markets aren’t the same — that active funds do outperform in bear markets? Of course, Sharpe’s insight should provide you with that answer. However, there’s also a recent Vanguard study on the subject.
Do Active Managers Outperform in Bear Markets
In the Spring/Summer 2009 edition of Vanguard Investment Perspectives, the firm examined the data covering the period 1970–2008 to determine whether active managers could turn their supposed advantage (being able to move to cash) into outperformance. The study looked at the returns of active funds during the seven periods in that timeframe when the Dow Jones Wilshire 5000 Index fell at least 10 percent and the six periods when the MSCIEAFE Index fell by at least that amount.
Despite acknowledging the data’s survivorship bias (poorly performing funds disappear and are not accounted for) Vanguard found:
Whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection and market-timing proves a difficult hurdle to overcome.
Past success in overcoming this hurdle doesn’t ensure future success. The degree of attrition among winners from one period to the next indicates that successfully navigating one or even two bear markets might be more strongly linked to simple luck than to skill.
Vanguard concluded: “We find little evidence to support the purported benefits of active management during periods of market stress.”
It’s also worth considering this amazing bit of evidence. Goldman Sachs studied mutual fund cash holdings over the period from 1970 to 1989. The study — discussed by William Sherden in his book, The Fortune Sellers — found that mutual fund managers miscalled all nine major turning points. You couldn’t get all nine turning points wrong if you tried!
The Bottom Line
The bottom line is that passive investing is the winner’s game, regardless of asset class or economic regime.
Larry Swedroe is director of research for The BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.
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