Investors face many choices and potentially adverse conditions while walking down the yellow brick road of investing. Using active or passive funds is one of those choices, and bear markets are one of those adverse conditions.

I often hear that active funds are like ruby slippers that can spirit investors to safety even as passive funds are buffeted by the bear market’s whirlwind. However, given the principles of the zero-sum game, can this really be the case? Active and passive and bears, oh my!

 

Lots of opportunity, limited success

To help answer this question, Vanguard research examined the record of flexible-allocation funds since 1997. These funds represent active management in the purest sense because they can pretty much invest in any asset or sub-asset class and can try to time the market to the best of their ability. Generally speaking, their common objective is to outperform a benchmark in any market environment. The chart below shows the record of these funds compared against a balanced benchmark during three bull markets and two bear markets.

 

Market-timing in bull and bear markets: A spotty record

Percentage of flexible-allocation funds that outperformed a 60% stock/40% bond benchmark, January 1997 through December 2016

Active management in a bear market

Notes: The balanced benchmark consists of the MSCI US Broad Market Index (42%), the MSCI All Country World Index ex USA (18%), and the Bloomberg Barclays U.S. Aggregate Bond Index (40%). Flexible-allocation funds are those defined by Morningstar, Inc., as having “a largely unconstrained mandate to invest in a range of asset types.” Data are through December 31, 2016.

Source: Vanguard, using data from Morningstar, Inc.

 

The results emphasize just how difficult it is for active management to outperform in any kind of market. A majority of flexible-allocation funds underperformed the benchmark in four of the five periods—and in both bull and bear markets. Even though the one outperformance occurred during a bear market, outperforming in one out of two instances does not a trend make!

 

A tough challenge in every market and in every land

While I’m not aware of related research published by a lion, tin man, or scarecrow, I am aware of long-standing research published by Standard & Poor’s in its S&P Dow Jones SPIVA report.1 The report details the performance of active funds versus various S&P benchmarks. The “Annual League Table” (page 4), included in each year-end report, highlights the challenges of active management year over year. In the most recent year-end report, from 2015, active management’s performance was equally mixed for years in which the market generated a negative return (2000, 2001, 2002, and 2008) as it was for years in which the market generated a positive return. The report is worth a look because it spans 15 years and 13 fund categories. The data are there; regardless of the market’s direction, achieving outperformance using active management is a challenge.

As we noted in The case for low-cost index-fund investing, the principles of the zero-sum game state that in a given market, for every position that outperforms, there must be a position that underperforms such that, in aggregate, the excess return of all assets in that market is zero. This is true regardless of market direction, including bear markets, and in all market segments, including those in The Land of Oz.2

 

I would like to thank my colleague Sarah Relich for her contributions to this blog.

 

 

1 S&P Dow Jones Indices, 2016. SPIVA U.S. Scorecard. Accessed March 7, 2017, at https://us.spindices.com/documents/spiva/spiva-us-yearend-2015.pdf.

2 Whether markets are efficient in The Land of Oz is up for debate, but we are confident that zero-sum-game principles still apply.