Does passive investing work in a bear market?

Warren Buffett has little faith in active funds and swears by index funds. Is passive investing still a good idea in a bear market?

“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

Warren Buffett, the legendary investor with a net worth of approximately $84 billion, made this observation in 2016.

Free investment advice from one of the world’s richest men, that’s like money in your pocket!

There’s no question this strategy has paid off in the past decade. As markets went up in a straight line, active funds found it hard to beat passively managed funds…

And with the latter you won’t have to surrender a sizeable chunk of your gains to your fund manager. As a result, lots of money has been shifting out of active funds and into passive ones.

Still, active funds claim they outperform passive funds in a bear market. They’re supposed to be in a better position to pick winners whereas passive funds simply track the market.

The FTSE fell 12.5% in 2018. The Dow Jones, S&P 500 and Nasdaq also finished the year in the red, which means we might be trading 2019 in bear market territory.

Is it still a good idea to invest in passive funds?

The power of passive

“The goal of the non-professional should not be to pick winners” – Warren Buffett, 2013.

Crystal balls that accurately predict the future on a regular basis are hard to come by.

Individual investors should therefore not waste time and money trying to predict the direction of individual stocks, says the Oracle of Omaha. They’re better off owning a cross-section of businesses which are bound to do well on average.

In practice that means investing in an index fund which tracks a particular market. These funds invest in a basket of stocks that’s designed to mirror the performance of that market as closely as possible.

Up until late last year, when stock markets saw their year’s gains erased in a short period of time, investing in index trackers was a solid investment strategy.

US stock markets had been going up in almost a straight line, which means the funds tracking it shared in the spoils.

As long as they were going up, investors would find it hard to gain an edge over the passive funds that tracked these markets. In fact, just 7% of active funds focusing on North America managed to beat the top tracker fund.

Buffett’s faith in low-cost index funds is absolute. In early 2008, he bet Wall Street investment firm Protégé Partners $1 million that the S&P 500 index would outperform a portfolio of hedge funds selected by Protégé over a 10-year period.

Naturally, Buffett came out on top. More than 200 hedge fund managers racking their brains for the best investment decisions proved no match for the nearly free index fund. The hedge funds returned 36% to their clients; the tracker 126%.

Unsurprisingly, the past decade sparked a revolution in passive investing. Outperforming a highly efficient market seems to be a fool’s errand, so why pay someone a hefty commission to try?

More and more money went from actively managed to passively managed. Almost $10 trillion has flooded into index tracking funds, which means they now handle nearly twice as much money as hedge funds and private equity funds combined.

It would appear that a growing group of investors is taking Buffett’s words as gospel.

From bull to bear

“Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game” – Warren Buffett, 2014.

Buffett’s cheap index fund blew handsomely-paid active fund managers out of the water over a 10-year period. He won his bet and of course the winner is always right.

But did the specific conditions of the past 10 years help Buffett win his wager? After all, a low-volatility bull market may not be the best moment for hedge funds to shine.

It’s hard to stand out in a bull market when the majority of stocks is going up. It doesn’t take a special skill to pick winners when just about every stock is a winner.

As John Husselbee of asset management fund Liontrust told Morningstar, the “rising tide to lift all boats environment has been a great breeding ground for passive investing”.

Now that the markets seem on a downward trajectory, are passive funds still a good place to put your money?

Put differently, if Buffett were to repeat his bet that index funds will do better than hedge funds over the next 10 years, could he win again if the playground is a bear market rather than a bull market?

If you had bought index tracking funds at their peaks in September, you’d now be down about 11% in the UK, 13% in the US and almost 25% in Germany.

Obviously, fund managers should find it easier to outperform trackers now compared to when markets went up. They should have more leeway to pick more strategically in a downturn and do more damage control than a fund that emulates the market.

But the problem with turning to an active fund is that it’s very hard to pick the right one.

“Performance persistence [of active funds] is poor,” writes Iain Barnes of Netwealth.

“Evidence suggests that investors who selected UK funds which had ranked in the top 25% of funds over the preceding three years ended up with a fund that was in the bottom 25% of peers more often than one which stayed in the top 25% for the subsequent three years.”

In other words, picking the right active fund may be just as hard as trying to time the market. Even if you pick the right fund, you’ll end up paying them a considerable share of your profit.

I can see the logic of simply sticking the same amount in a tracker every month and be done with it,” says Income For Life investment director Greg Robinson. “Especially if you are investing in the FTSE 100 with its current dividend yield and the dividends are re-invested.”

We’ve seen that this strategy could make sense in a bull market. But what about a bear market? Could it still pay off then?

“A bear market is actually the best time to be buying shares, not selling them. And a passive fund is the cheapest and easiest way to do that.”

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