Don’t Bet on Active Management to Beat the Volatile Market

‘Active managers have nowhere to go to escape except into cash ... and going to cash almost never happens,’ says Morningstar's John Rekenthaler

During severe market downturns such as the one we’ve been experiencing so far this year, financial advisors might logically assume that actively managed investments are a better choice than passively managed funds for investors.

Passively managed index funds or ETFs by their very nature will, of course, mimic the performance of the market, which has been declining. Actively managed funds, on the other hand, have the potential to do better, though they can also do worse.

Since their managers select specific stocks, they can potentially outperform the broader market, and they have the ability to hold cash, which can cushion the blow when the market is falling while having funds on hand to snap up shares on the cheap as opportunities arise.

Many actively managed funds, in fact, outperformed the broader market during the 2000-2002 market rout, when the tech bubble burst, largely by avoiding the hottest shares that were crushed in the avalanche.

”Stock-picking may be key if investors are to realize upside, while limiting downside if the market goes as badly wrong as some fear,” writes Brian Gorman, an analyst at Cerulli Associates, in the latest Cerulli Edge report. 

But advisors shouldn’t count on active management to outperform passive strategies. In 2008 during the financial crisis and Great Recession, actively managed funds fell along with major stock market indexes across the board — in large cap and small, value and growth and U.S. stocks and foreign stocks.

“There was no escape route save for raising cash, and few active U.S. stock funds did that in any measure,” writes John Rekenthaler, vice president of research at Morningstar in a recent column, “Where’s the Payoff for Active Investing?”

Rekenthaler tells ThinkAdvisor he’s “skeptical about the general notion that actively managed funds will give you pretty much the upside and be able to limit the downside. It’s not true for most of them…. Be cautious when you hear that.”

But it has been true when a particular sector has become very popular and highly valued, like tech stocks were in 1999 during the tech bubble and Japanese stocks were in the late 1980s, when they accounted for about 40% of the MSCI EAFE international stock index. Those active managers that avoided or limited their exposure to such hot sectors outperformed their benchmarks and most other active fund managers, says Rekenthaler.

That begets the question: Is today’s stock market one of those times when a particular asset class is in a bubble or approaching bubble territory? Apparently not. U.S. and international equities have been falling almost in tandem with the rout in commodities.

“I’m worried this will be like it was in 2008 when everything went down together,” says Rekenthaler.

And when that happens, “active managers have nowhere to go to escape except into cash ... and going to cash almost never happens with active managers overall,” says Rekenthaler. “They are not paid to be in cash.”

They apparently did not hold much cash during the latest market downturn.  From May 22, 2015, through Jan. 15, 2016, less than half of large-cap and mid-cap funds beat their respective Russell indexes, according to Morningstar data showing average returns for growth, blend and value funds.

Large-cap growth funds fared the worst – only 23% beat their respective index benchmark. Small-cap funds showed better-than-even odds to outperform but at best, just 61% of small-cap growth funds beat their benchmark.

So should advisors counsel their clients to hold more cash now? Yes, says Rekenthaler. “If there’s a bear market this year and an investor wishes to ease the pain, the investor will have to do that on his or her own. Active managers are not paid to be in cash.”

Jane Leung, allocation strategist at iShares, BlackRock’s ETF unit which manages more than $1 billion in assets, suggests another strategy, one that is neither completely passive nor active.

“Everyone is pretty resigned to the fact that volatility is here to stay,” says Leung. “I wouldn’t recommend going to the sidelines and staying in cash [but rather] actively picking ETFs, choosing specific sectors or countries,” including ETFs that hedge foreign currency exposure.

“It’s very difficult to outperform as an active manager, particularly in markets like U.S. or other developed markets where markets are very efficient. But that said, because of volatile times we’re in with divergent monetary policies, you have to be a lot more active and selective in your investments.”

She tells ThinkAdvisor that “holding more cash is fine,” provided investors put that money to work when investment opportunities present themselves, which isn’t often the case.

“Investors make the mistake of holding too much cash and fall short of investment returns in the long run.”

Ironically, one sector she likes now is tech, where many companies are hoarding cash.

“Investors now should be more actively passive, using the diversification and transparency of passive ETFs but picking their spots,” says Leung.

She also favors currency-hedged European ETFs, which should benefit from the European Central Bank’s easier monetary policy, as well as Asian stock ETFs, including specifically those ETFs that focus on Japanese stocks.

“Know what you own — know index providers as well as active managers, know their strategies and make sure they deliver performance they say are going to deliver. That’s a lot more challenging in this environment.”

Rekenthaler recommends that investors and advisors looking for active management screen for funds that have a track record of competitive total returns with low risk and below-average cost as well as a corporate culture that focuses on money management rather than banking or brokerage, what Morningstar terms its “stewardship rate.”

He also notes that value funds tend to perform better in bear markets that follow overvalued markets rather than bear markets inspired by fears about an economic slowdown. Actively managed growth funds tend to do better than that case.

--- Check out As Eaton Vance Rolls Out NextShares, Value of Active Management Questioned on ThinkAdvisor.


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