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Does Active Management Protect You During Bear Markets?

Index funds don't do well in bear markets. When the market is declining, you need a fund manager at the helm, piloting the fund to the safety of cash when the market's storms hit, while plucking up the ridiculously undervalued securities that bear markets leave in their wake.

Sound familiar? If you've paid even a bit of attention to the financial markets over the years, you likely recognize the above as one of Wall Street's most cherished bits of conventional wisdom.

Despite my and various others' efforts over the years to debunk this myth, it's demonstrated remarkable staying power, primarily because it makes so much sense.

Index funds by definition are always fully invested, with essentially their entire portfolio in stocks no matter how dire the circumstances, and regardless of how seemingly obvious a coming market decline appears to be.

Actively managed funds, on the other hand, have a great deal more flexibility. Their managers can sell stocks and hold cash when they anticipate a downturn, thereby avoiding the worst of the bear market and leaving them in fine shape to swoop in and pick up bargains at the market's bottom.

But as is often the case, what makes sense in theory isn't borne out in practice.

Part of the problem is that what hinders active fund managers in bull markets -- high relative expense ratios -- is a problem that also applies in bear markets. In fact it might be worse.

With expenses that can easily be 1 to 1.5 percent higher than a comparable index fund, active fund managers are starting behind the proverbial eight ball -- they need to outperform the market by that much just to keep even with an index fund.

When the market's soaring by double-digits per year, the attention of many investors will be drawn not to the fact that their fund lagged the market by a bit. Instead, they're likely to be captivated by how much their investment has increased. Lagging the market by a percentage point or so is easy to overlook when that's a relatively small share of your total return. (Leaving aside the tremendously large impact such a lag has over the long-term.)

But when bear markets hit, those expenses loom large, consuming a much larger share of the market's return. If the market declines by 5 percent in a period of time, that extra 1 percent in expenses now reduces your relative return by 20 percent.

The lower the market's return, the larger the impact of costs.

The second problem is that for all their talk, active managers as a group have yet to actually demonstrate any sort of ability to tiptoe through bear markets. As a matter of fact, they're no better at figuring out what the market has in store than you or I. (And I, frankly, stink at it.)

If active fund managers were truly capable of timing the market, we would expect to see their cash holdings increase at market tops (as they begin to protect their investors' cash), and decline at market bottoms (as they put that money to work in attractively valued markets).

But that's not what happens. Consider the past four-and-a-half years, from 2007 through June 2011, during which we've seen more than our share of market volatility. During that period, the average equity fund has held 4.1 percent of its portfolio in cash, according to ICI data. For most of the first part of that period (as you might recall), the market was in a severe decline. At the end of February 2009 -- mere days before the the market reached its bottom -- the average fund had 5.74 percent of its portfolio in cash -- the highest amount during this period, and an increase of 40 percent above the average.

In early March 2009 the market began a two-year-plus climb, during which those cash ratios slowly fell. They reached their low point in -- you guessed it -- April 2011, just days from the market's most recent peak, with an average cash position of 3.37 percent, nearly 20 percent below the period's average.

So much for the notion of that steady, experienced hand at the wheel. To paraphrase Warren Buffett, fund managers were fearful when they should have been greedy, and greedy when they should have been fearful.

If anything, fund managers in this period have been a perfect contrary indicator -- investors would have been well served by going in precisely the opposite direction fund managers were.

And finally we have their performance during the recent market decline. For the year-to-date through August 19, the average domestic stock fund has earned a return of -12.58 percent, trailing the -10.42 percent return of Vanguard's Total Stock Market Index fund. A full 72 percent of all domestic stock funds lagged the index fund, despite the index fund's supposed "handicap" of being fully invested during the market downturn.

Trying to predict the the market's short-term movements is a fool's game. It's impossible to know whether the market will be up or down tomorrow, next week, or next month. You know that. I know that. Even most active fund managers -- deep down -- know that. And thus a strategy that's built upon identifying and profiting from the market's short-term movements is destined to fail.

No matter what the market conditions, the traits that handicap active management persist, which result in very low odds for long-term success no matter what the market conditions. The evidence supporting this is clear and compelling across all sorts of bear market, bull markets, "stock-picker's" markets, and the like. And sooner or later, conventional wisdom will catch up.

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