Active management is no panacea for down markets

This fall's market forecast calls for an increase in volatility, which means that financial advisers can expect to hear a lot about how active stock pickers can help cushion against a drawdown.

However, much like the fabled stock picker's market, the message is more sales pitch than reality.

The theory — or marketing pitch — says that active managers can better protect assets when stocks take a nosedive because they can do things such as raise cash, stick to the highest-quality stocks or a combination of both. An index, meanwhile, has to stay fully invested at all times, so it will take investors to the market's bottom.

Unfortunately for active managers, a recent study that looked at the past 20 years of mutual fund returns found the promise of active management in down markets is too good to be true.

“It's a good story, but most managers don't succeed in down markets,” said Harold Evensky, co-author of the study and president of Evensky & Katz LLC.

The study, “Modern Fool's Gold: Alpha in Recessions,” looked at the monthly returns of 1,511 mutual funds from 1990 to 2010 and found that, on average, actively managed stock funds weren't able to add enough alpha to offset their fees during recessions.

“From an investor standpoint, they added no value,” Mr. Evensky said.

The funds' performance during recessions was an improvement over how they behaved when the economy was growing.

During periods of expansion, the average mutual fund cost investors about 1% of performance a year, the study found.

Of course, not all managers fail to add alpha during a downturn. Think of American Funds circa the technology bubble, for example. The vast majority of those that did were unable to repeat the feat during the next downturn.

In fact, just one out of five portfolio managers who outperformed during a past recession was able to do so again, according to the study.

American Funds, the company Mr. Evensky calls the “Rolls Royce” of actively managed equity funds, was one of those that failed to repeat its success during the tech bubble when the financial crisis struck.

Even though the statistics paint a dire picture for active management, Mr. Evensky isn't in the all-passive investments camp.

“The index wins most of the time, but we're agnostic,” he said.

“We look at the people, the process and the performance,” Mr. Evensky said. “If an active manager can pass those screens, there's a good chance of our clients getting some of that fund in the future.”

As Mr. Evensky said, most advisers would benefit from keeping an ope! n mind about actively managed funds.

It is important to let the fund's process, expenses and performance drive the decision making. though, instead of a story that sounds too good to be true.