March 26, 2020
The global pandemic that has whipsawed markets has also ended the 10-year-old bull market run. When most of the extreme equity-market volatility subsides – as it eventually will – there are a number of possibilities for the direction of stocks. These can range from a more prolonged bear market with notable ups and downs that gradually moderate, to eventual recoveries.
Throughout, when stock markets are volatile, defensiveness matters – and so will active managers. Many actively managed portfolios can offer a measure of downside protection in falling markets, and an inherent ability to be nimble in markets of all types.
Passive and active strategies are on opposite sides of the fence when it comes to the inevitable downturns that follow long advances in equity prices. With passive investments, investors are beholden to follow along as indices retreat, as they have done in dramatic fashion at times in recent weeks. Actively managed portfolios, on the other hand, can be flexible and tactical. Sweeping downdrafts affect all equity investors, but active managers can use research-intensive security selection and adjust portfolio positioning to achieve a defensive posture that seeks to mitigate the impact of market setbacks.
Active versus passive relative performance
Sources: Morningstar Direct, Macquarie Investment Management. Chart shows the difference in performance between large-cap active and passive funds, relative to the S&P 500® Index over the period.
As the dust settles
As uncertainty grips markets and causes extreme performance in the initial stage of a bear market, there may be few opportunities for active managers to search out dislocations. As the dust settles a bit, active managers should have more opportunities that result from indiscriminate selling and passive strategy liquidation, which is part and parcel of indexing.
That said, we don’t discount the fact that index strategies have a place and can be good at capturing market upside. But when markets retreat or are shocked by an external event, there may be little gratification in capturing 100% of an index’s decline.
This brings us back to the notion of actively managed portfolios with the flexibility to respond.
Active can exploit market movements
Even in the best of times, markets are inefficient, and some stock markets more so than others. Active management has the potential to exploit opportunities created when investor sentiment causes prices to overshoot in either direction. If the stock market were completely efficient, for example, every stock would be perfectly valued and no active manager would be able to outperform the market. The reality is that markets allow adept active managers the chance to find opportunities, especially in less efficient pockets of the market such as small-cap stocks, emerging market equities, and other international equities.
In challenging markets, it’s worth reminding investors that active management has the potential to take advantage of market inefficiencies in several ways:
- avoiding companies that may be underperforming but remain part of an index
- adjusting a portfolio’s asset allocation to reflect a shifting macroeconomic outlook
- implementing sector rotations to minimize downside risk
- exploiting mispricings in market segments that fewer analysts cover, like small-cap stocks and some international stocks
- optimizing individual long-term positions via trading strategies.
A primary rule: Stay in the game
While fear of the unknown has been driving the markets, history shows that eventually rationality prevails in volatile periods, and asset prices return to being driven by business fundamentals. As this transition occurs, skillful active managers – those bottom-up stock pickers who rely on fundamental research – should be positioned to outperform passive indices. All of this requires an initial premise: staying in the market despite the volatility. Investors who jump out run the risk of sealing their losses, and not participating in gains.
Of course, no degree of active management can insure against periods of underperformance, but by virtue of their research-based allocations, active managers can take positions in tune with prevailing market conditions. This type of downside protection is often a key part of the value propositions put forth by many active strategies that aren’t found in passive strategies – the potential to survive or even thrive as markets work through extremely volatile periods.