Taking an active approach to down markets

Part 3: Exploring the truth about benchmark investing

Taking an active approach to down markets

As noted in our previous blog on the myths of benchmark investing, active and passive strategies have cycled through periods of over- and underperformance for the last 25 years. In this blog, we focus on performance during down markets, and show that active strategies have historically captured less of the downside than market benchmarks. We’ll explain why this is a very important distinction.

Limiting downside risk is a critical part of investing due to: 

The asymmetry of losses – To be successful over the long term, it’s important to limit losses. Here’s why. If you suffer a 50% drop in the value of your portfolio, you would then need to double your money to get back to where you were. This is a very tough position to be in (both financially and emotionally), and it may impact your decision-making process because of…

The emotion – Many risk-averse investors find it difficult to remain in the market during periods of volatility. They may give in to emotion and sell at precisely the wrong time during those dramatic swings. Implementing strategies to help shield portfolios against large losses may help the average investor stay focused on long-term goals. There is also the issue of…

The timing – Some investors may try to buy passive strategies during bull markets and active strategies during bear markets. However, the ideal times to do this are notoriously difficult to determine. Market tops and bottoms are usually seen most clearly in the rearview mirror, and this hurts those investors who wind up chasing performance rather than staying ready for it.

Invesco study shows active funds were less risky during market turmoil

In 2016, Invesco published a study analyzing the performance of over 3,000 mutual funds covering five distinct market cycles. 1 Funds with active share scores of 60% or greater 2 were compared with their passive benchmarks in a variety of performance measures. We found that 64% of high active share funds (see Figure 1) limited downside risk better than their passive benchmarks across all market cycles studied.

Figure 1: Percentage of high active share assets and funds that captured less of the downside than benchmarks

Percentage of high active share assets and funds that captured less of the downside than benchmarks

Source: FactSet Research Systems, Inc.

Our study also suggests that active managers, on average, have had better risk-adjusted returns than purely passive strategies. As illustrated in Figure 2, aside from the most recent period that we studied (where passive outperformed), for past cycles going back almost 20 years, our study shows active managers outperformed passive strategies on a relative and risk-adjusted basis as defined by the Sharpe ratio.2

Figure 2: Prior to the most recent cycle, active funds have had a history of outperforming on a risk-adjusted basis

active funds have had a history of outperforming on a risk-adjusted basis

Source: Morningstar Direct, used with permission.

Invesco compared smart beta versus passive performance results in 2016 — please see our study for additional information.

Key takeaway

As mentioned above, limiting losses is a key part of any successful investing strategy, in our view. According to our 2016 study of over 3,000 mutual funds, nearly two-thirds of actively managed funds provided better downside risk than the passive funds. Actively managed funds (including those employing smart beta strategies) also generally recorded higher risk-adjusted returns. Talk to your financial advisor about diversifying among active and passive strategies, so that you can potentially benefit from their varying cycles of outperformance.

  1. Invesco, “Think active can’t outperform? Think again,” August 2016. We analyzed 17 US open-end mutual fund Morningstar categories, which encompass all of the major US and foreign equity capitalization styles defined by Morningstar. About 3,300 total funds resulted from this primary screen. Funds were studied from July 1998 through December 2015. Equal-weighted figures represent the number of funds that outperformed a specified benchmark/value in each period relative to the total number of funds with calculable data in that period. Asset-weighted figures represent the percentage of assets of funds that outperformed a specific benchmark/value in each period relative to the total assets of funds with calculable data in that period. For market cycles and trailing periods, assets were averaged using beginning- and end-of-period data.
  2. Active share measures the percentage of equity holdings in a fund that differ from the benchmark index. Higher active share indicates lower holdings similarity between a fund and a particular index. A fund and an index that have no commonality would yield an active share of 100%. Funds that hold derivatives may actually generate an active share score above 100% due to financial leverage.

Important information

Blog header image: lzf/Shutterstock.com

Beta is a measure of risk representing how a security is expected to respond to general market movements.

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

Past performance cannot guarantee future results. An investment cannot be made in an index.

The Sharpe ratio is a measure of risk-adjusted performance calculated by dividing the amount of performance a portfolio earned above the risk-free rate of return by the standard deviation of returns; a higher Sharpe ratio indicates better risk-adjusted performance.

Smart beta represents an alternative and selection index-based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both, in active or passive vehicles. Smart beta funds may underperform cap-weighted benchmarks and increase portfolio risk.

Tracy Fielder
Product Management Director
Strategist — Rethinking Risk

Tracy Fielder is a Product Management Director for Invesco covering US Value strategies. He works with Invesco’s US Value investment teams and client portfolio managers to develop sales and marketing programs, positioning Invesco’s product line across all global distribution channels.

In addition to his product management responsibilities, Mr. Fielder is part of a team that develops the themes, researches the data and presents the concepts of Invesco’s Rethinking Risk program. This educational program seeks to encourage a holistic view of risk, considering market history, investor psychology/behavior, and asset allocation theory/application. This program also looks at the impact of risk parity, a portfolio construction approach that diversifies across sources of risk in relation to various market and economic environments.

Prior to joining Invesco in 2010, Mr. Fielder was vice president of Investment Research at VALIC (Variable Annuity Life Insurance Co.), responsible for leading a team of analysts overseeing the selection and monitoring of all mutual fund managers and sub-advisors utilized for defined contribution retirement plan clients. Before joining VALIC, he was an account executive at Van Kampen Investments where he was in charge of marketing and sales for the Van Kampen mutual fund product line distributed by Morgan Stanley Dean Witter financial advisors. He entered the financial industry in 1993 as a marketing coordinator for PaineWebber.

Mr. Fielder earned an MBA from Houston Baptist University and a BBA, cum laude, with a concentration in finance from the University of Houston. He holds the Series 6, 7 and 63 registrations.

Marie Jordon
Senior Product Manager

Marie Jordon is a Senior Product Manager for Invesco. She works with a number of Invesco’s fundamental equity investment teams to develop sales and marketing programs, positioning Invesco’s product line across all global distribution channels.

In addition to her product management responsibilities, Ms. Jordon works on a team dedicated to Invesco’s Rethinking Risk thought-leadership program. The Rethinking Risk program articulates Invesco’s holistic approach to risk, by considering market history, investor psychology and behavior, and asset allocation theory and application. The program also discusses the merits of diversifying portfolios across sources of risk in relation to various market and economic environments.

Ms. Jordon assumed her current role in 2009. From 2002 – 2009 she worked as an investment services analyst working with Invesco’s subadvised, offshore and institutional clients. She entered the financial industry in 1999 when she joined Invesco, working in the retail distribution channel

Ms. Jordon earned a B.B.A. in Marketing from Texas A&M University in College Station. She holds the Series 7 and 66 registrations.

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