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Active Managers and Bear Markets: Don't Believe the Hype

The mutual fund industry has trotted out a number of anti-indexing arguments in the 34 years since John Bogle launched the first index fund in 1975. They're un-American; investors won't be happy with "average" returns; it's a stock-pickers' market; it's not hard to find a successful mutual fund manager. One by one, those arguments have been exposed over the years.

Yet one argument seems to resurface every time the markets hit a dip: index funds only do well in bull markets, and you need a skilled manager to protect you in bear markets.

Vanguard did a nice job debunking that myth in a paper Larry Swedroe highlighted a few weeks ago. But if we dig a little deeper, we uncover yet another flaw inherent in actively managed equity funds.

As we're all painfully aware, the markets hit their recent low point in early March of this year. The table below shows how funds in each of the nine Morningstar categories fared against their benchmarks from the market's peak in October 2007 through February 2009, a period in which the Dow Jones Wilshire 5000 was off 41 percent.

Morningstar Category

% of Funds Beating Their Benchmark:
Oct. 2007 - Feb. 2009
Large Blend 57%
Large Growth 16%
Large Value 82%
Mid Blend 32%
Mid Growth 22%
Mid Value 52%
Small Blend 39%
Small Growth 32%
Small Value 54%
All Funds 47%
As you can see, a majority of funds in five of the nine categories -- and a majority of funds overall -- trailed their respective indexes in this particular bear market. Only one category -- large value funds -- was a standout, with an amazing 82 percent of all funds outperforming the S&P/Citigroup 500 Value Index. It's not as if the funds in this category were providing a great deal of protection from the bear -- the average fund in this category lost 42 percent while the Index lost 47 percent -- but a win is a win.

In the subsequent two months the market has bounced back quite nicely. So it's interesting to take a look at how that comeback has impacted those outperformance figures. The table below tells the tale.

Morningstar Category % of Funds Beating Their Benchmark:
Oct. 2007 -
Feb. 2009
% of Funds Beating Their Benchmark:
Oct. 2007 -
April 2009
Change From First Period
Large Blend 57% 52% -5%
Large Growth 16% 21% +5%
Large Value 82% 83% +1%
Mid Blend 32% 28% -4%
Mid Growth 22% 15% -7%
Mid Value 52% 40% -12%
Small Blend 39% 34% -5%
Small Growth 32% 20% -12%
Small Value 54% 46% -8%
All Funds 47% 48% +1%
When we take the two-month recovery into account, something rather amazing happens: relative performance in seven of the nine categories drops, often by a startling amount. The seven declining categories fell by an average of seven percent; the two categories that saw an increase over the first period rose by an average of three percent.

This swing is attributable to one of the "benefits" that active management advocates often cite: the ability of active managers to sell stocks and go to cash when bear markets hit. Index funds, by definition, remain fully invested at all times, no matter what the market conditions. Active managers, on the other hand, are free to pull back the reins a bit and become more conservative when they feel that conditions warrant. This freedom is presumably part of the expertise you're paying for when you hire a professional manager, and is the basis for the claim that managed funds fare better in down markets.

The problem is that there's no evidence that mutual fund managers are any better than anyone else at predicting what the future holds for the stock market, a fact starkly illustrated by their performance during the current bear market. At the end of October 2007, right at the market's peak, the average equity fund held 3.8 percent of its assets in cash. At the end of February 2009, just days from the market's recent bottom, they held 5.9 percent in cash -- an increase of 55 percent as stock prices began their ascent.

If managers truly had the predictive powers that so many like to attribute to them, those ratios would be precisely reversed: they would have been hoarding cash as the market crested, and putting it to work as it bottomed. Instead, we find that they were merely doing what millions of amateur investors were also doing as the bear clawed their portfolios -- selling stocks and raising cash at precisely the wrong time.

The result? Even if you're steadfastly maintaining your asset allocation when all around you are running for the exits, your fund manager could well be undermining your efforts by joining the crowd.

Does that sound like expertise that's worth paying for?

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