The Evidence-Based Investor

Having your cake and eating it — the myth of downside protection

Posted by Robin Powell on October 21, 2015

There are all sorts of myths that it suits the fund industry to perpetuate, perhaps the most insidious of which is that active funds are better than passive in bear markets. Index funds, we keep being told, fall with the markets whereas active funds provide the reassurance of “downside protection”.

The broker Tilney Bestinvest has been busy peddling this particular illusion lately. According to research conducted by, you’ve guessed it, Tilney’s own research department, four-fifths of active equity fund managers have protected investments during a market downturn more effectively than their passive peers. The “findings” were quoted in articles by several financial media outlets.

Downside protection sounds great. What’s not to like about a fund that offers the potential of outperformance when markets are on the up with the reassurance of limiting your losses on the way down?

The problem is that it’s impossible to design a portfolio that provides market-beating performance at low risk. Investors are compensated for the risk they take. If you want higher returns you must accept greater risk. There has to be a trade-off. High returns with low risk is like having your cake and eating it.

There is a very simple reason why active funds sometimes outperform index funds in bear markets. With equity index funds, you know what you’re getting — 100% equities. Most active funds, on the other hand, hold small amounts in cash, and sometimes in bonds as well, which gives them an advantage if markets fall (and a disadvantage if they rise).

It’s this ability to run for safety which proponents of active investing claim gives active managers an edge in bear markets. But there are two important issues they overlook.

First, the exposure of active funds to safer assets is still fairly modest. As Jack Bogle has said, “a 5 to 10% tail of cash cannot possibly wag the dog represented by a 90 to 95% equity position”.

Second, as Morningstar has shown, active funds generally hold equity portfolios that are riskier than the portfolios of major indexes, which tend to be dominated by higher-quality, larger-cap stocks.

These two factors help to explain why, contrary to the conventional wisdom, managed funds generally do worse in market downturns than index funds. Look at these examples from the US:

  • In the correction of mid-1990, the S&P 500 fell 14.7%, but the average actively managed fund fell 17.9%
  • In the bear market of the summer of 1998, the S&P 500 dropped 19%, compared to 22.2% for the average managed fund
  • In its 2008 Indices Versus Active (SPIVA) scorecard, Standard & Poor’s concluded: “The belief that bear markets favour active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes.”

To be fair to active managers, there is some evidence to show that active strategies have performed marginally better in recessions. But even if you take the best-performing funds during the most successful five-year period for active managers in recent times — the period ending September 2002 — closer examination of the data reveals a rather different picture. Vanguard found that fewer than a third of managers were able to repeat their outperformance in the following five-year period. Furthermore, fewer than 45% outperformed their benchmarks in the bear market of 2007-2009. Both results fell far short of the 50% outcome that you would expect from random chance.

In other words, even the top performing managers fail to repeat any skill they showed in one bear market during subsequent bear markets. Yes, there will be funds that outperform in the next bear market — whenever that might be — but your chances of picking those funds in advance are worse than flipping a coin.

Ultimately, as much as the likes of Tilney Bestinvest would like us to believe it’s all about skill and performance, it ultimately boils down to cost. As the Nobel-winning economist Professor William Sharpe pointed out in his paper The Arithmetic of Active Management, the average passive investor must — yes, must — outperform the average active investor, because of the considerable additional costs that active investing entails. The cost of using the active funds that Tilney recommends will put a huge drag on your investment performance which any fund manager would struggle to overcome through stock selection or market timing.

The lesson is simple: stick to low-cost index funds regardless of the market conditions (and even Tilney’s research acknowledges that passive beats active in bull markets). If you want downside protection — and are willing to forgo a portion of your expected returns to have it — then hold a cash or bond reserve and save yourself an absolute fortune in fees.

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Robin Powell

A journalist and broadcaster, Robin Powell is a campaigner for positive change in the investing industry. He runs a communications company for the evidence-based investing sector called Regis Media.

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