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Do Bear Markets Favor Active or Passive Investing? It Depends.

April 6, 2020  | by Mark Bennett, Kristofer Kwait

COVID-19 | Investment Strategy

In the ongoing debate about active versus passive investing, conventional wisdom posits that active investing outperforms passive in recessionary or bear market environments. The question is: Will the expected pattern hold up in the current sell-off and what will almost assuredly be the ensuing recession? The answer: it depends.

Thus far in the present market environment it has not been true. That’s because what it depends on is the structure of the sell-off, how long it lasts and how much forced selling takes place. In the bear market of 2001-02, for example, the sell-off was not rapid, there wasn’t a lot of forced deleveraging and individual stocks responded to underlying fundamentals. That environment worked for active fund managers. When markets decline slowly—not suddenly as is the case currently—active managers tend to hold more cash (which, granted, can be called market timing) and they may also hold more defensive securities. On the other hand, a quick, hard-hitting bear market is characterized by significant deleveraging, correlations that go way up and stocks trading on liquidity more than anything else. It’s a sell-what-you-can environment. There were days recently when utilities were down more than the market—not what one would ordinarily expect.  

The chart below shows the correlation of various stock sectors in the U.S. Typically, correlations are between 0.3 and 0.6,  reflecting price discovery and  market participants’ evaluation of the fundamentals of sectors and underlying companies. That environment provides active managers with the opportunity to use their research skills to identify winners and losers and, hopefully, add value for investors on both the upside and the downside. Further, the chart also shows that sector correlations during the recent sharp equity market plunge rose to 0.9 as investors sold indiscriminately.

CH1-Sector-Correlations

This is an environment that doesn’t work well for active managers, hedging or relative value strategies. Fundamentals simply take a back seat when stocks that are not even impacted by the virus are down 20, 30 percent or more in just a few days. While this is negative, of course, it does set up opportunities to capture alpha going forward. That’s what happened in the recovery of 2009, after the 2011 retrenchment and in the immediate wake of the Brexit referendum. What will lead us out of this is managers that can stay the course and take advantage of attractive pricing opportunities and benefit when the market starts to incorporate data and fundamentals into stock prices.  And while we don’t know where and when those attractive opportunities will present themselves, they most assuredly will.  Lastly, we also draw comfort from working with long-tenured managers who have demonstrated an ability to weather prior downturns and, eventually, benefit when the market environment begins to turn.

Authors

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Mark Bennett is a member of the Commonfund Asset Management Investment team and is primarily responsible for asset allocation, manager sourcing, due diligence, and investment monitoring for investment portfolios. Prior to joining Commonfund, Mark was an Investment Consultant for defined benefit services at CIGNA Retirement and Investment Services. He was an asset allocation analyst and consultant for CIGNA-Connecticut General Pension Services, Inc. Previously, Mark was a benefit technician for CIGNA Retirement and Investment Services. He received a B.S. from Bryant College and his M.B.A. from the University of Hartford. Mark is a CFA charterholder and is a member of the Hartford Society of Financial Analysts and the CFA Institute.
Mark A. Bennett
Managing Director, CFA
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Kristofer Kwait co-leads the Commonfund Asset Management Investment team and oversees investments in marketable equities, fixed income, hedge funds and real assets as well as analytics. He serves on the Commonfund Asset Management Executive Group and chairs the Investment Committee and is a member of the Commonfund Asset Allocation Committee. Prior to his current role, Kris was head of the Hedge Fund Strategies Group and previously served as head of hedge fund research with responsibility for overseeing the design and implementation of proprietary models for manager selection, portfolio construction, and risk management. Before joining Commonfund, Kris was a proprietary trader at both Andover L.L.C. and A.B. Watley, where he managed relative value equity strategies. Prior to his experiences as a trader, he was a stockbroker at Smith Barney. Kris attended pre-college at Juilliard School of Music, has a B.S. from Purdue University and an M.B.A. from the Yale School of Management.
Kristofer Kwait
co-Chief Investment Officer
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.