Investors have been challenged with deciphering plenty of mixed messages this year from the financial news as a result of the choppy market waters. One of these messages is that actively managed funds perform better during times of market turbulence. This may arise from the notion that active managers can make tactical shifts to change their allocations based on market conditions to “better position themselves”.
However, a historical analysis of US-domiciled equity funds has found no meaningful relationship between market volatility and outperformance by active managers. In other words, traditional active investments may give you more concern than comfort during market uncertainty.
Exhibit 1 below illustrates this. The orange line shows the rolling three-year standard deviation for US stock returns. The blue bars represent rolling three-year outperformance rates by active US equity funds. As you’ll see, there is little relation between the level of outperformance by active managers with the level of volatility.
For example, the rolling averages of daily volatility from 2014 to 2019 were consistent, but the percent of funds outperforming during these rolling periods was not, ranging from 23-37%. Furthermore, at no point over the period from 2005-2021 did the rolling three-year average outperformance rate exceed 50%.
|Exhibit 1: Rolling Three-year Outperformance Rates for Active US Equity Funds vs. Stock Market volatility (January 2005–December 2021) |
Past performance is no guarantee of future results. Market volatility computed each month using standard deviation of Fama/French Total US Market Research Index daily returns. Monthly volatility observations are then averaged over rolling three-year periods formed at the end of each year. Outperformance rates are computed over the same rolling three-year periods and are calculated as the percentage of active US-domiciled equity funds that survive the period and outperform their respective Morningstar category index net of all fees and expenses. Sample of active managers consists of funds categorized as active US equity by Morningstar. Fund returns are average returns computed each month, with individual fund observations weighted in proportion to their assets under management (AUM). Index benchmarks are those assigned by Morningstar based on the fund’s Morningstar category. See additional, important information below.
Rather than trying to search for mispriced securities to outperform the market, we believe it is more prudent to rely on market prices. Dimensional’s annual study on the fund industry, The Fund Landscape, revealed that as of December 31, 2021, only 26% of equity funds had outperformed their benchmark and survived over a 10-year period. The same number reduced to 23% for 15-year time periods, and just 18% for 20-year time periods1.
If markets did not effectively incorporate information into prices, opportunities may arise for active managers to identify and capitalize on mispriced securities. If this were the case, we’d expect to see a higher percentage of funds outperforming benchmarks than what the data reveals. In the study, we see these outperformance figures dwindle even further for funds with higher expense ratios and higher turnover, which tend to be more common in actively managed funds.
There is no doubt that market downturns are unpleasant for all market participants. Investors can reduce exacerbating the experience by adhering to core principles via a systematic approach to investing. By focusing on such an approach, which is backed by a long history of research, investors can remain broadly diversified, maintain a consistent asset allocation, and still position themselves to capture higher expected returns in the market.