Kevin’s Corner: Actively Addressing Today’s Market

Kevin E. Donovan, CFA February 24, 2016

As stocks surged from 2012 through 2014, there were many stories in the press about how passive investment strategies represented by exchange-traded funds (ETFs) were superior to actively managed strategies such as mutual funds in terms of both performance and cost.  The theory is that ETFs that merely track the performance of an index such as the S&P 500 produce higher returns and cost much less than mutual funds controlled by a portfolio manager making investment decisions in common stocks.  The truth, as is often the case, is more complex, so let’s try to simplify it.

It may be hard, now that markets are not going straight up anymore, but remember how good it felt to be an investor from 2012 to 2014.  The S&P 500 jumped 16%, 32% and 14% in those three years and most sectors saw dramatic gains.  With the economy growing, unemployment falling and the Fed stimulating, the market was not differentiating between good and poor companies.  Everything looked much better than it did just a few years before during the recession.  Passive strategies even did very well in asset classes such as real estate and small company stocks, where active managers have long claimed their specialized knowledge results in better performance.  In good times, passive strategies often outperform and everyone feels like a genius because all one has to do is hop on and enjoy the ride.

That ride came to an end last year when, for the first time since 2008, the S&P 500 declined.  That decline does not tell the whole story of the U.S. stock market performance last year, however.  There were some sectors, such as technology, that did extremely well that are underrepresented in the S&P 500 index.  This is where active management shows its advantages.

Those specialized areas of real estate and small company stocks also saw the reemergence of active outperformance in 2015.  The T. Rowe Price Real Estate fund gained 4.8% last year, much better than the Dow Jones Select REIT index’s 0.8% gain.  The small-cap Undiscovered Managers Behavioral Value fund gained 3.4% while the small-cap Russell 2000 index fell 5.7% – a tremendous level of outperformance.

During times of market stress, it pays to limit the downside so you don’t feel the full force of a declining stock market.  If a stock falls by 20% it has to gain 25% just to get back to even, while a stock that is down 10% only has to rebound a little over 11%.  We look at the long-term downside capture of funds we use to determine how it may react during market declines.  A fund manager with a lower downside over a ten-year period is generally more conservative and is likely to lose less than the overall market during subsequent declines, preserving more of your investment dollars than if you had invested in an index fund.  Studies have shown that limiting losses is a vital factor in achieving superior long-term returns.

There will always be persuasive arguments on both sides in the active vs. passive debate.  In raging bull markets, passive strategies tend to do very well, but that advantage diminishes in more normal times or when the market declines.  Looking for answers in returns over short periods of time or in times when the market is only going up is not the place to find them.  Each strategy has a role in different market environments and we use both to address different needs.



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