Outperformance in Down Markets 100% of the Time?

By Preston McSwain, January 4, 2019

The title is a little click-baitish, but with all the bold “down-side protection” product pitches floating around and filling up my inbox, I figured I’d throw out this provoking question.

I didn’t make it up, however.

How one could have outperformed “100% of the time” in the “longest” bear markets was detailed in a report published by a well-respected research center in 2001 (more on this below).

A lot has been written about the outperformance of index funds as compared to active managers.

Headlines and emotional pitches also abound about the dangers of index strategies and how they might “exacerbate” investor losses in a downturn.

What does the research show?

An S&P Dow Jones report from 2009 might be a good place to start.

It showed this:

“A majority of active funds in eight of the nine domestic equity style boxes” underperformed their appropriate indices in the 2008 down-turn and produced “similar outcomes” in the 2000 and 2002 bear markets.

In an arguably more robust fashion, in 2001, the Schwab Center for Investment Research also found the following in the study I referenced at the beginning of this post.

After analyzing the performance of over 2000 actively managed funds and 120 index funds during market declines between December 1986 and March 2001:

Index funds outperformed actively managed funds in 55% of the down markets
In the worst downturns, defined as declines of 10% or more, index funds outperformed actively managed funds 75% of the time
In the longest downturns, defined as declines of 5 consecutive months or longer, index funds outperformed actively managed funds 100% of the time

These studies aren’t perfect, but they do seem to provide useful down-market data.

And, if you think Buffett, Munger and many other seasoned professionals are correct when they suggest that the key to success is avoiding mistakes, then the independent evidence seems to be clear.

The probability is quite high that an investor who tries to pick an active equity investment manager at the correct time in either up or down markets will make a lot of mistakes.

Many will admit that “average” funds have not performed well relative to index funds.

Some of these same professionals, however, often tout how they can apply their resources and processes to consistently pick top managers who can add value.

I appreciate their confidence and a big part of me wishes this was so. In a past life, I was a Managing Director of a large firm that offered what were supposedly down-side protection funds and had a team that promoted our skill in active manager selection.

Unfortunately, peer reviewed research published by the Journal of Finance found this related to the long-term value of the pitches many in the industry have given:

“No evidence” that recommendations from institutional manager selectors add value.

As we’ve written more than one time, we are not trying to win a debate about which style of investing is better.

Active strategies can be appropriate depending on the circumstance and, as we also wrote, “if investing in an active strategy makes an investor feel more comfortable and will help them to stick to a plan more easily then, regardless of the relative performance versus an index, it might be the correct choice.”

We are just hoping that the next time you hear a bull or bear market pitch, you will ponder how it is being presented, the emotions it invokes, and how it might be designed to drive investor behavior.

Remember, “Never ask a barber if you need a haircut.”

Instead, consider this quote from David Swensen, who on behalf of Yale has proven himself to be one of the most successful investors in the world across many market cycles:

“When you look at the results on an after-fee, after-tax basis over a reasonably long period of time, there’s almost no chance that you end up beating an index fund – the odds are 100 to 1.”

Special thanks to Dougal Williams, who had saved a hard copy of the 2001 Schwab Research study that does not exist anymore on the internet (see the link above or the first link below in Related Reading).

Related Reading:

Which Way to Go in a Down Market?

Are Selectors Good at Selecting?

Relative Alpha®

Do Index Funds Make Active Managers Better?

What Do You Need?