This year’s crisis has refuted one common idea – that actively managed funds do better in bear markets. Figures from Trustnet show that so far this year most funds in the UK All Companies sector have done even worse than the 16.4 per cent loss on Scottish Widows' All-Share tracker (selected not because it is the best performing tracker but because it is one your correspondent owns). This is a worse performance than last year, when 62 per cent of funds actually beat that tracker.
Such underperformance is not a quirk of the UK. In fact, in the US active managers have done even worse. New research by Lubos Pastor and Blair Vorsatz at the University of Chicago has found that almost three-quarters of actively managed funds underperformed the S&P 500 during the slump and early phase of the recovery in the index.
But is this year’s performance a fair test of fund managers? In one sense, no. The pandemic is a genuinely exogenous event that no amount of financial expertise could have predicted. Fund managers cannot therefore be blamed for not foreseeing it in the way we might more reasonably blame them for failing to foresee bear markets caused by overvaluations or normal cyclical downturns.
On the other hand, though, managers are charging the same fees as they do in normal times and so should be judged by the same standards. And in fact this year should have given funds more chance than usual of beating the market. Professor Pastor says that this year has seen “unusually large price dislocations”. At their low points in March the S&P 500 and All-Share index were both one-third below their pre-pandemic levels and both have since bounced back – the S&P much more so than the All-Share. That should have generated lots of mispricings which fund managers – if they had genuine ability – could have profited from.
So why didn’t they? My table below gives a clue. It shows a clear pattern. When small stocks outperform big ones, most funds outperform a tracker. But when small-caps underperform, so too do active managers. In 2015, 2017 and 2019 small-caps did well, as did actively managed funds. But in 2016 and 2018 small-caps did badly and so did active managers. With small-caps having underperformed so far this year, this pattern has continued.
| Fund managers' track record | ||||||
| 2020 | 2019 | 2018 | 2017 | 2016 | 2015 | |
| % beating Scottish Widows tracker | 47.5 | 62.3 | 30.6 | 62 | 26 | 68.1 |
| Small caps relative to FTSE 100 | -5.5 | 0.4 | -5.9 | 3.4 | -6.5 | 14.9 |
| Momentum relative to FTSE 350 | 10.9 | 4.9 | -8.8 | 20.8 | 5.4 | 21.6 |
| Defensives relative to FTSE 350 | 9.1 | -13.5 | -8.9 | 6.9 | 0.8 | 13.6 |
| Source: Trustnet and IC |
There’s a simple mathematical reason for this, which rests on the fact that stock market indices weight stocks by market capitalisation, so Unilever’s market cap of £120bn gives it 40 times the weight of Bellway’s £3bn. Now, when small-caps rise more than the FTSE 100 it means that most shares are beating the index. Which means that anybody who picks stocks at random has a better than 50-50 chance of beating the market. Even if fund managers have no ability at all, therefore, most should beat the market when small-caps do well. Which is just what happens.
This alone, however, doesn’t prove that fund managers really do have no ability – although Cass Business School’s David Blake has concluded from his research that the majority of them are “genuinely unskilled”. Instead, there are two other possible explanations for this pattern.
One is that most managers do in fact have some ability. Christopher Polk at the LSE and colleagues have shown that their handful of best picks do beat the market. Most funds, though, own more than a handful of stocks simply because a few big positions would be difficult to sell quickly. Some of their shares simply add liquidity to their funds. And when most stocks beat the market, it is these liquidity-motivated buys that do well – at the expense of hurting performance when most stocks underperform.
Secondly, if only a few big stocks beat the market fund managers will pay a huge penalty for just one or two misjudgments even if they are correct about most other stocks.
This is why US managers have had such a tough time. As I write, the S&P 500 is only 0.2 per cent lower than the level at which it began the year. But this resilience owes much to good rises in a few huge stocks such as Alphabet (US:GOOGL) (up 14 per cent), Apple (US:AAPL) and Microsoft (US:MSFT) (up 30 per cent) and Amazon (68 per cent). These four alone have contributed 6 percentage points to the S&P this year. The fund manager who mistakenly underweighted just one or two of these giants paid a huge performance penalty even if his other calls were decent.
If these two considerations exonerate fund managers, something else doesn’t. It’s that this year has actually been good for evidence-based stockpickers.
There are two strategies (and perhaps only two) which we know to work well because we’ve evidence of their success in different times and places: defensive and momentum stocks. Both have done well this year; my no-thought portfolios of them have beaten the FTSE 350 by 9 and 11 per cent, respectively. The fact that most fund managers have done badly despite this suggests that most do not use these strategies very much. Which is odd, given that the evidence base in favour of them is so strong.
All this suggests an alternative to actively managed funds, even leaving aside defensives – which you can buy via several investment trusts, many of which have big positions in stocks such as Unilever (ULVR) and Diageo (DGO). Quite simply, hold a small-cap ETF. Because it is likely to beat the market when most active managers do, it gives you exposure to the likelihood of outperformance, at lower cost than most active funds.
Whether you do this or not, the fact is that it is simply not true that active managers do better in bear markets. We should consign this to the dustbin of investment myths, alongside the idea that older people should own fewer stocks or that equities are a safe long-term investment.
