PASSIVE PERFORMANCE THROUGH THE BEAR MARKET

It is commonly accepted knowledge around the world that we have seen a sustained period of outperformance by passive investment solutions when compared to their active management counterparts.  In the latest SPIVA scorecard released by S&P Dow Jones Indices it was revealed that over the past 5 years 84.47% of US Large Cap Active funds delivered lower returns than if one was invested in the S&P500.  Similarly in South Africa over the past 5 years 90.48% of South African Equity funds underperformed the S&P South Africa 50 index. 

The active management industry has often attributed this underperformance to the strong equity returns that were delivered for the best part of these last five years with the common myth stating that passive strategies (where one seeks to track large parts of the market) will outperform in bull markets but the active fund (where the managers actively select stocks to try deliver market beating returns) will outperform in the bear market.  The argument is that if you are in a passive solution through a bear market and the market comes off, your portfolio will lose value in line with the market losses.  The active manager however can be more flexible and take evasive action by moving to cash, deploying that at a later date to very attractive, and appealing valuations.  Very compelling but does it hold any water? 

In 2022 we have seen the dramatic global increase in inflation being countered by central banks hiking interest rates.  The higher cost of goods together with the higher cost of financing has placed companies under strain and equity valuations have come off this year.  In fact they have come off far enough for this year to be declared a bear market, with US stocks down 27.5% from their peak in early January to their trough in the middle of October.  The bear market theory should dictate that this year we have seen an outperformance by active management.  The data however says sadly not.

Analysis of performance

In South Africa there are 118 unit trusts in the Global Equity General category.  Amongst these funds there are some passive solutions but the offerings are predominantly actively managed.  Using data taken from Morningstar we looked at the year-to-date performance of the 30 largest funds.  You’ll note from the chart below that bar just the one fund all other solutions lost money which fits with the fact that we are in a bear market.  We have ranked the ZAR returns from best to worst and in yellow we have highlighted the return of the Satrix MSCI World Equity Index Feeder Fund, which is the largest passive solution within that category.

The active management theory states that in a bear market active management will outperform but actually just 7 out of 30 funds outperformed.  This places the passive solution near the top of the 2^nd quartile of return rankings over a very short period of just 10 months.  A far greater number of funds underperformed with a large 22 out of 30 (73%) funds not beating the passive solution.  This despite the conditions being in active management’s favour. 

The challenge of selecting funds

We have previously written about the challenge of selecting funds and the performance of the 30 funds in the population used for the sample demonstrates this.  Of the 30 largest funds within the Global Equity General category 24 of them have performance figures stretching back at least 5 years.  We have ranked the annualised 5 year return figures of these 24 funds and once again the Satrix MSCI World Equity Index Feeder Fund is highlighted in yellow. 

The passive Satrix fund ranked 5 out of 24 so firmly in the 1^st quartile with a very sizeable 79% of funds underperforming the passive solution over the 5 years ended October 2022.  

We had seen that in the year to date rankings seven funds had outperformed the passive solution for the 10 months ended October 2022.  To highlight the performance of these magnificent seven we have coloured their five year returns in pink.  What is clear is that those that have outperformed in 2022 have tended to overall underperform quite significantly.  If one looks at those highlighted in pink one tends to find a value style investment philosophy.  Value has struggled against growth for a number of years, but growth shares tended to perform worse this year which is why value outperformed.  But whether growth was outperforming, or value was outperforming, one thing is very clear – the passive solution will invariably give you near top quartile returns. 

Whether we are in a bull market or whether we are in a bear market the data demonstrates that only a handful of active managers ever outperform the passive solution.  Active fund managers can make poor decisions, such as choosing the wrong investments or timing transactions poorly, since they are susceptible to the same human emotions as ordinary investors, such as greed or fear. 

Passive investing has frequently outperformed active because of its lower fees.  This is because active investing is typically more expensive (you must pay research analysts and portfolio managers in addition to additional costs due to more frequent trading).  As a result, many active managers do not beat the index after deducting costs.  Are these the active managers within your portfolio?

Magwitch Offshore is a leading provider of Global Balanced ETF portfolios with products in all major currencies. Magwitch utilises an advisor distribution model and their portfolios are available through offshore endowment structures provided by some of the larger Insurers.