Publications

- June 1, 2020: Vol. 7, Number 6

Active beats passive: And the outperformance of quality managers grows during larger market losses

by Damian Handzy

Given the current economic conditions, many of us are also taking the time to ensure our financial portfolios are well taken care of. For that reason, we took the time to investigate the evidence for or against active management outperformance during market downturns. The conclusion is strong: Quality active managers have significantly outperformed the broad market during the worst four market downturns over the past 25 years.

We examined more than 1,000 actively managed U.S. funds from 1995 through 2020 and found that, on average, they consistently beat the broad Russell 1000 index. In falling markets, the top 25 percent of managers (by performance) beat the market 60 percent of the time, while the top 5 percent of managers beat the market 75 percent of the time.

Conventional wisdom says that because passive investment has no awareness of tail risk events while active managers do (or at least should), that good active management should outperform passive investments during times of market stress. Our analysis shows that quality active managers not only beat passive investment during downturns, but that the outperformance grows with larger market losses.

We examined the eVestment Large Cap US Equity manager universe from 1995 through 2020 and compared the monthly manager returns, corrected for survivorship bias, to the monthly returns of the Russell 1000. The median manager underperforms the Russell 1000 46 percent of the time in up markets and outperforms the Russell 1000 some 51 percent of the time in up markets, showing that the average manager does indeed provide near-benchmark returns. However, the top 25 percent of managers, who outperformed the benchmark only 51 percent of the time in up markets, beat the benchmark 60 percent of the time in down markets. The spread between up and down markets grows when considering the top 5 percent of managers who beat the benchmark 75 percent of the time in down markets outperformed up markets only 60 percent of the time.

It seems that downside risk protection is a core benefit of top-performing active equity managers.

We next identified four periods of market crisis over the past 25 years from August 2000 through September 2002 (with a 41 percent loss), the global financial crisis from October 2007 through February 2009 (with a loss of 50 percent), the debt downgrade from April through September 2011 (with a loss of 15 percent), and the taper tantrum from September through December of 2018 (with 13 percent loss).

When we examined each of these downturns, we saw that active management did better during the average down-market month. In times of large market losses, the best 25 percent of managers and the best 5 percent of managers each increased the fraction of time they beat the index.

Good managers outperform the passive index in market downturns and outperform even more during crisis periods.

Focusing on the four market crises, we measured the average monthly underperformance/overperformance of the five percentile categories: 5th percentile (lowest performers), 25th, 50th, 75th and 95th percentile (best 5 percent), during each of the four crises. The results: Of the four crises studied, the tech bubble had the largest outperformance by managers, likely because its epicenter was an easily identifiable and hedge-able industry. Each of the other crises shows a consistent outperformance of over 40 basis points per month for the top 25th percentile and well over 140 basis points per month for the top 5th percentile.

Finally, we organized the overall active manager outperformance of the Russell 1000 into four quartiles to show that the outperformance of the average active manager increases with severity of downturn. During the most severe downturns, active managers as a group provided market outperformance of almost 30 basis points per month.

These results show that active equity portfolio management provides downside protection that increases with worsening market downturns.

As the COVID-19 pandemic causes significant disruption in global markets, the temptation to redeem from active to passive should be tempered by the realization that active management provides a level of downside protection not observed in passive markets.

 

Damian Handzy is chief commercial officer at Style Analytics.

Forgot your username or password?