Navigating COVID-19 volatility: Another Nail in the Coffin for Active Management
It seems to me that the narrative around asset management is dichotomous. On the one hand, academics and data-heads favour a more rules-based, passive approach. In stark contrast, the active argument is alive and well among many financial advisers. Coming from an Economics background, I was surprised to discover just how entrenched some mythologies are within finance. Arguments around “navigating volatility”, “outperforming the market” and “using professional expertise to protect your money” presuppose that managers add value in times of crises. At the root of these assertions is the idea that market timing is possible, and that active management allows you to get out early in a crash.
Financial jargon often disguises this underlying assumption. For example, two UK managers argued that “compared to an index/rule based investment strategy, we [active managers] have been proactively analysing both our top-down (country, industry and style) and bottom-up (stock level) decisions.” This sounds great, and complicated enough that outsiders won’t argue with it.
Unfortunately, the data don’t support that this strategy is effective. Bailey (2020) notes that 80% of active funds under-performed the bear market. Only 58 of the 270 funds in the UK All Companies Sector lost less than the -32% benchmark for the month. In one of the most dramatic months in the history of the stock market, 1 in 5 active managers added value. Those numbers are less than inspiring, to say the least. What’s more, it is unlikely that a given investor can select these funds. Conventional wisdom might suggest that you should select funds that have recently outperformed, since they are more likely to continue to outperform. This is not true, most funds that outperform in a given month are less likely to outperform in the following month. In other words, you would be gambling, and it wouldn’t be a very intelligent gamble at that. For data on this, read this article.
But is this time different? Every crisis has its own narrative, and that narrative is always scary. Every crisis is different because circumstances are never identical. Simultaneously, however, every crisis is the same, because the media is always incentivised to give us the most visceral version of a story that it can conjure, since views and clicks are money. I constructed a model using historical S&P 500 data to determine the efficacy of active management in limiting losses. This kind of model has been tested rigorously, but it was interesting to see the results for myself. In my model, I took money out of the market following market downturns that were uncharacteristically large. My model portfolio was 100% invested in the S&P 500 index, and it began in 1935 with £100,000.
If a given month had returns lower than any of the previous 12 months, I took money out of the portfolio and waited for two consecutive months of positive returns greater than 1% before putting money back in. Notwithstanding incidences of capital gains and income tax that would be incurred with this strategy or associated fees, this strategy performed well in times of consistent market downturns. In the 1970s for example, where the market incurred months of negative performance, there were times where the active approach outperformed the index significantly. However, the results over the 85 years that I analysed were surprising, even for someone who was skeptical of market timing to begin with. Of course, there are problems with my market timing model, and someone else may build a more effective model. The main point of my analysis is that time in the market, not market timing, is how a long-term investor should seek gains.
Figure 1 illustrates the canyon that gapes between the active vs passive approach. Buying and holding since 1935 would have outperformed my market timing model by nearly 250%. I have not even factored in the fees and taxes that would take huge bites out of an active portfolio. I can practically hear some people saying “obviously I would be choosing good managers, not ones who use a rule like yours”. Again, I urge you to read this.
Source: Own calculations using data from Yahoo Finance (2020)
What is the takeaway from all this? Well, to be honest, nothing new. As an investor, you get what you don’t pay for. High fees and under-performance are positively related, at least in the historical data. If you are investing for the long-term, buy and sit tight. When you hear an adviser suggesting getting into cash to “protect” your investment, run! Run far away and relax, firm in the knowledge that the best thing you can do is relax. Relax, and move to an ever more conservative portfolio as you near the age where you will need your savings.
Bailey, T., 2020. Did active funds provide protection for UK investors in the market’s recent turmoil?. [Online] Available at: https://www.moneyobserver.com/news/did-active-funds-provide-protection-uk-investors-markets-recent-turmoil [Accessed 22 June 2020].