A Viral Market Update VIII: A Crisis Test – Value vs Growth, Active vs Passive, Small Cap vs Large!

The shift of funds from passive to active has been occurring for a long time, but the shift was small early in the process. In 1995, less than 5% of money was passively invested (almost entirely in index funds) and that percentage rose to about 10% in 2002 and 20% in 2010. In the last decade, that shift has accelerated, as you can see in the graph below:

Source: Morningstar

Active investors have argued that their failures were due to an undisciplined bull market, where their stock pricing expertise was being discounted, and that their time would come when the next crisis hit. There were also dark warnings about how passive investing would lead to liquidity meltdowns and make the next crisis worse. If active investors wanted to have a chance to shine, they have got in their wish in the last few weeks, where their market timing and stock picking skills were in the spotlight. With their expertise, they should have managed to not only to avoid the worst of the damage in the first few weeks, but should have then gained on the upside, by redeploying assets to the sectors/stocks recovering the quickest. While there is anecdotal evidence that some investors were able to do this, with Bill Ackman‘s prescient hedge against the COVID collapse getting much attention, I am sure that there were plenty of other smart investors who not only did not see it coming, but made things worse by doubling down on losing bets or cashing out too early.

As we look at the bigger picture, the results are, at best, mixed, and hopes that this crisis would vindicate active investors have not come to fruition, at least yet. I looked at Morningstar’s assessment of returns on equity mutual funds in the first quarter of 2020, measured against returns on passive indices for each fund class:

Note that the first quarter included the worst weeks of the crisis (February 14- March 20), and there is little evidence that mutual funds were able to get ahead of their passive counterparts, with only two groups showing outperformance (small and mid-cap value), but active funds collectively under performed by 1.37% during this period. Focusing on market timing skills, tactical asset allocation funds (whose selling pitch is that they can help investors avoid market crisis and bear markets) were down 13.87% during the quarter, at first sight beating the overall US equity market, which was down 20.57%. That comparison is skewed in favor of these funds, though, since tactical asset allocation funds typically tend to invest about 60% in equities, and when adjusted for that equity allocation, they too underperformed the market.

Looking at hedge funds in the first quarter of 2020, the weighted hedge fund index was down 8.5% and saw $33 billion in fund outflows, though there were some bright spots, with macro hedge funds performing much better. Overall, though, there was little to celebrate on the active investing front during this crisis. On the market liquidity front, while much has been made of the swings up and down in the market during this crisis, the market has held up remarkably well. A comparison to the chaos in the last quarter of 2008 suggests that the market has dealt with and continues to deal with this crisis with far more equanimity than it did in 2008. In fact, I think that the financial markets have done far better than politicians, pandemic specialists and market gurus during the last weeks, in the face of uncertainty.