Are you better off in active or passive funds when markets fall?

Active or passive funds in a bear market

As anyone involved in selling investment products will tell you, fear sells. We’re afraid of uncertainty and we hate losing money more than we like gaining it. So when markets fall and scary forecasts abound, we instinctively look for solutions.

The problem is, apart from bailing out of equities, there isn’t one. Giving in to your emotions like that might give you temporary relief rom the stress you’re under, but it’s rarely in your long-term interests.

The time to think about the level of risk you’re taking is before volatility strikes. Once it’s already happening, you’re too late do anything about it, unless you’re willing to turn your paper losses into actual ones.

The biggest fear when markets fall is that it’s the start of a long bear market. In most cases, falls are merely corrections but, now and again, they herald something more serious. The sell-off prompted by the collapse of Lehman Brothers in September 2008 is a classic example.

That’s why, when markets wobble, we tend to read articles in the media about actively managed funds performing better in falling markets. At times of market uncertainty like these, the marketing message goes, you need an active manager to provide some “downside protection”.

Active funds and the “downside protection” myth

The notion that you’re any better off in an active fund in falling markets sounds perfectly plausible, but it is in fact completely groundless.

There are so many funds to choose from that there will always be some which outperform in a market downturn, simply by the law of averages. In many cases it’s simply because most active funds include an element of stocks and bonds for liquidity purposes.

But studies have shown that, on the whole, active funds will fall just as far as the market, and in many cases further. For example:

  • Lipper studied the six market corrections between 1978 and 1990, and found that while the average loss for the S&P 500 was 15.12%, the average loss for large-cap growth funds was 17.04%.
  • Goldman Sachs analysed the cash holdings of active funds between 1970 and 1989 and found that fund managers miscalled all nine major market turning points.
  • S&P Dow Jones Indices compared the performance of active funds and index funds in the aftermath of the crash in 2008 and concluded: “The belief that bear markets favour active management is a myth.”

Markets are always uncertain. It’s precisely that uncertainty, and the risk that the value of our investments might suddenly fall and not recover for several years that explains the so-called equity premium.

So, decide on your capacity of risk, invest accordingly and ride out the inevitable volatility. In other words, embrace uncertainty — and steer clear of products that claim to protect you from it.

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