Market downturn puts spotlight on active management

One of the best ways active managers can earn their money in a down market is by holding cash, something index funds can't do

Jan 2, 2019 @ 2:00 pm

By Jeff Benjamin

The momentum toward passively managed index investing is expected to lose some steam as the volatility in the financial markets shines fresh light on the benefits of active management.

It is as cyclical as the markets themselves, and a lot of financial advisers are already making asset-allocation adjustments to bring active managers off the bench as the stock market heads south.

"No question that this downturn in the market will favor actively managed strategies going forward," said Dale Wong, president of Missio Investment Management.

"Greater volatility and dislocation in a sharp downturn typically affects all equities, even those companies whose future prospects for growth and earnings are much more attractive," he added. "This creates dislocations in the market that enhances opportunities that active managers can take advantage of with greater likelihood of asymmetrical returns over a three-to-five-year investment horizon."

A decade-long bull market for stocks has made an easy case for riding along in low-cost index funds, but the spike in volatility over the past three months is triggering some altered viewpoints.

The S&P 500 Index declined by 4.38% last year. But the number that is getting more attention is the 13.52% decline during the fourth quarter.

Meanwhile, actively-managed large-cap growth funds, as tracked by Morningstar, declined by an average of 2% last year, though they were down 15.42% in the fourth quarter.

But inside those broad averages are such extremes as a 17% full-year return by the Fidelity Advisor Series Growth Opportunities Fund (FAOFX). The $680 million fund was down 10.4% in the fourth quarter.

The best-performing large-cap growth fund in the fourth quarter was the $265 million Madison Investors Fund (MNVRX), which was down 7.63%.

"To me, active management is risk management," said Barry Mandinach, executive vice president at Virtus Investment Partners.

"When people buy index funds, most of them don't know what they're giving up in exchange for the low fee," he added. "They're taking on a valuation- and quality-agnostic approach to investing. And that's like driving a car with no brakes, which is fine if you're only going uphill."

One of the best ways active managers can earn their money in a down market is by holding cash, which is something index funds are not able to do.

"In times of market volatility and selloffs, active management is getting paid a premium to keep you from losing too much ground," said Todd Rosenbluth, director of mutual fund and ETF research at CRFA.

"They can go to cash, they can raise cash, and they can buy on the dips, whereas index funds have to track the index," he added.

Dennis Nolte, vice president at Seacoast Investment Services, said cash management is the secret weapon for most active managers.

"If a fund holds cash and is highly correlated to the S&P 500, it'll outperform during down markets," he said.

While index investing isn't yet free, it is dirt cheap, which means most active managers must gain at least 100 basis points over an index just to cover the management fee differential.

But the tradeoff, from an adviser's perspective, is the ability of an active manager to buy low during periods of market volatility.

The flipside of being able to go to cash is that active managers suffer a "cash drag" during bull market periods, which is another reason index funds are more competitive in bull markets.

"Active mutual funds typically trail in the strongest of markets and perform better and better as that tails off," said Paul Schatz, president of Heritage Capital.

"The longer the stock market becomes challenging, the more the active fund manager takes measures, whether right or wrong," he added. "One thing they certainly do is run with higher cash levels. Just that alone can help reduce fee drag. Active managers will also often reduce beta in a portfolio to reduce risk if they don't want to raise cash."

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