Active vs. Passive in a down market

I’m writing a research paper concerning the effectiveness of active vs. passive management in down (bear) markets for work. Wondering if we have any strong believers one way or another: What’s your reason, how do you support your view? Do you think active is more useful in certain asset classes? and vice versa? Not looking for a definitive answer, just opinions (to reflect sentiment in the industry) Thanks

Sounds like passive, not active, research is being used for this study.

true… We are analyzing performance data but also wanted to get the gut-feel from those in the trenches

I’ll give a couple of points, none of which I will/can back up with any hard data points. I think active management in bear markets can be beneficial, especially for taxable portfolios to harvest large losses, leading to possible outperformance after-taxes. In addition, I think active management makes sense for certain asset classes over others. For example, small cap tends to be a less researched/followed universe versus the Dow 30, therefore the opportunity for price inefficiencies could be higher as info is not as widely dispersed or known. I would argue this holds true for emerging markets as well to some degree. With that said, we use a mixture of both in daily practice. I also think you typically find people who want to believe in active management in this industry as they want to think they are adding value, and then you find the old veteran who has thrown the towel in on it and just indexes.

if i recall the L3 curriculum - tax loss harvesting is an overhyped issue. its more of a cashflow issue than a returns issue. you need to defer taxes many years to get any kind of meaningful advantage.

well from a practical usage of it we dont find it to be overhyped…at least to those concerned with maximizing after tax returns.

Well, most passive investing doesn’t involve shorting or market neutral. So in bear markets, active strategies have a statistical advantage. Whether they can maintain that advantage in a bull market is a big question.

bchadwick Wrote: ------------------------------------------------------- > Well, most passive investing doesn’t involve > shorting or market neutral. So in bear markets, > active strategies have a statistical advantage. > Whether they can maintain that advantage in a bull > market is a big question. Yeah, I think active management is actually more beneficial in down markets then in bull markets, managers who take a strict value/capital preservation perspective tend to outperform in down markets relative to the index. In bull markets they tend to underperform because due to their contratarian nature they dont buy into hyped up stocks.

Out of the 100 largest active mutual funds that benchmark themselves against the S&P 500, 71 of them are underperforming YTD.

I think you’ll find that quality managers will outperform by much more in down markets. I’m rather new to the industry but I have some trading experience and have been able to trade the tops and bottoms of the last month or so, generating a lot of gains, pulling ahead of the benchmark by about 8%, but I’ve been behind because the benchmark gets its higher than normal dividends whereas I’ve been avoiding financials and energy for most of the year, missing those dividends. So I believe people who are much better than me at trading can reap some huge rewards. But those active managers working off value metrics are getting hammered for sure. The issue isn’t tax losses, etc. The only thing that would assist good active managers in a bear market is volatility as smart traders will buy HUGE weakness and sell HUGE strength. BUT at the same time, I wouldn’t be surprised if I ended up giving back my gains on the benchmark should we get a rally and I’m not fully invested.

Hmm… I guess it boils down to the fact that there are varied types of active management. If you are truly good, you should be able to outperform your benchmark in good times or bad times, which is why one is often measured relative to a benchmark rather than in absolute returns (there are other reasons for benchmarking too, such as making sure that different levels of decision making stay internally consistent when grouped together). A crashing market is usually accompanied by panicked selling, which, for a value oriented investor suggests that there are likely to be good companies oversold in a rush. That would suggest outperformance possibilities increase, but one is not likely to see the results of those decisions for at least a few quarters. For funds that can have short positions (most mutual funds can’t), funds can take advantage of hedging, which will make them look much better than comparable benchmarks. That will make active managers who can hedge (and do it at least somewhat intelligently) look very good. However, the appropriate benchmarks are then probably not things like the S&P or other broad market indices.

Bchadwick, But at the same time isn’t it typically the active funds doing the overselling on the way down as an index would only be adjusting its volume weighting to reflect price changes?

I appreciate all the comments, looks like we are getting some good ideas batted around

Again it comes down to the variety of active funds there are. A bunch of market neutral funds that might be selling to deleverage will likely push down long prices and push up the prices of what they are selling in a rush. A value fund that is less levered may take advantage of this by selling stuff that has gone up (because they are now overpriced - both the neutral fund and the value fund would agree on that) and buying things that have moved down. In fact, I’m coming to believe that delegeraging is what is adding so much confusion to the market. There may be consensus about what things are good things to own now, but the fact that anbunknown proportion of people simply have to reverse their positions 180 degrees just to delegrrage pushes prices the wrong way. Then others see that prices are acting strange and then start to doubt their models. Soon there are twice as many models as doubts, and no one wants to risk anything and the whole system freezes up. Hmmm maybe a new blog topic there.