Years ago, I saw a cartoon picturing two Victorian-era doctors discussing a patient. “What did you prescribe for Jones’ rheumatism?” asked the first; the second answered “A cold bath and a brisk walk every morning.” “Good God, man, that will give him pneumonia!” said the first. “I know,” replied the second doctor, “I made my reputation curing that.”
Somehow I was reminded of this exchange when I learned from this morning’s news that some institutional investors, smarting from recent losses, are considering increasing their commitment to active equity management. Their operating assumption seems to be that active managers will do a better job of capital preservation in a challenging and volatile market.
There’s certainly some plausibility to this argument. It turns out, however, to be another beautiful theory mugged by a gang of facts. The facts come from our periodic SPIVA reports, which compare the results of actively-managed mutual funds against passive benchmarks. Weak markets, it turns out, are no panacea for active managers. In 2008, e.g., 54% of large-cap U.S. funds underperformed the S&P 500. Results were even worse for mid- and small-cap managers (75% and 84% underperformers, respectively).
Statistics say, in other words, that moving from passive to active as a way of managing market volatility is likely to make performance worse, not better. Fortunately for anxious investors, passive strategies which focus on the lowest volatility segment of the equity market are most likely to outperform precisely when the market is weakest. Consider, for example, the S&P 500 Low Volatility Index and its cousin, the S&P 500 Low Volatility High Dividend Index:
Both of these indices are designed to attenuate the returns of the S&P 500 in both directions; historically they have both tended to underperform market rallies but outperform when markets are weak. Their reliability as defensive vehicles has far exceeded that of active management. Investors concerned about continuing volatility and market weakness should consider indicizing their defensive strategies.