Years ago, after learning in school that no two fingerprints are alike, my kids spent weeks trying to match their fingerprints to other people to disprove their teacher. Besides the practical aspects of a limited amount of test subjects, they never came close to proving the teacher wrong (although they kept thinking they were). While fingerprints do have similarities in their makeup, trying to find two identical ones would be near impossible.¹
Bear markets have a glaring similarity to this analogy. While such markets all involve market stress, no two are alike and they can be caused by an assortment of factors, including unexpected changes in monetary policy, political events, overvaluations, bank failures, natural disasters, wars, and deleveraging in various forms and combinations.
Trying to anticipate when these catalysts will take place and their effect on the equity markets has proven to be quite difficult, even for professional money managers. However, we believe certain factors can improve the probability of success using active management.
Two bears, different fingerprints
The dissimilarities in performance between the various sectors and segments of the market during the last two bear markets illustrate why active managers may have such a hard time outperforming.
When the tech bubble burst in the early 2000s, IT, telecom, and utilities were the worst-performing sectors. During the global financial crisis, REITs, financials, and industrials were the ones to avoid. In fact, REITs had been the best-performing sector during the tech crash, and utilities was one of the best during the great financial crisis.
Performance of equity sectors during tech crash and global financial crisis
Notes: Calculations are based on the annualized returns over the relevant time periods for the various sectors. The return of the REIT sector was calculated from monthly Dow Jones US Select REIT index returns. All other sectors calculated from monthly S&P 500 sector returns. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Source: Vanguard calculations.
When comparing the last two bear markets using a nine-box investment style framework, large growth underperformed and mid and small value outperformed in the aftermath of the tech bubble, but large growth was the best performing during the global financial crisis and large value the worst performing.
Leaders and laggards changed when looking at the market from the nine-box framework
Note: Calculations are based on the annualized returns over the relevant time periods for the segments of the market using relevant S&P index returns. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Source: Vanguard calculations.
Challenges for active
Active managers are generally not exempt from this unpredictability either. The top-performing active managers during the tech crash were no more likely to stay in the top half during the great financial crisis than end up in the bottom half or be liquidated or merged. We found this by taking all surviving funds after the dot-com implosion and bucketing them by performance quartiles. We then looked at how the top-performing quartile of funds performed during the subsequent bear market.²
Subsequent bear market performance of active funds originally ranked in the top quartile for the prior bear market
Note: Subsequent bear market rankings (November 2007 through February 2009) for U.S. equity funds ranked in the top quartile during the prior bear market (September 2000 through February 2003) by the highest and lowest cost quartiles. The ranking takes all active U.S. equity funds within each of the nine-box Morningstar categories based on their excess returns relative to their stated benchmark. Past performance is no guarantee of future returns.
* Sources: Vanguard calculations using data from Morningstar.
By comparison, random outcomes would show 25% of observations in each quartile category. Without even making the assumption that a majority of the liquidated/merged funds would have been ones that fell into the bottom quartiles, it’s clear that success in one bear market does not guarantee success in the next.
That said, our example also illustrates that outperformance in lower-cost funds is relatively more persistent than in higher-cost funds. This supports our research that while it’s not easy identifying an active manager who will remain a top performer from one environment to the next, investing in lower-cost managers offers the best chance of success across all situations. Additionally, you must have patience through the inevitable periods of underperformance that even the most successful of managers goes through. These guidelines don’t guarantee success, but they give you a better chance of active management helping you reach your goals than the chance of finding identical fingerprints.
¹ Galton, Francis. Finger Prints. London: MacMillan and Co., 1892. In this highly influential book, Mr. Galton calculated that the chance of two individuals having the same fingerprints was about 1 in 64 billion.
² Funds that were either liquidated or merged during the time period between the two bear markets or during the great financial crisis fell into the liquidated/merged bucket.
- Diversification does not ensure a profit or protect against a loss.
- All investing is subject to risk, including the possible loss of the money you invest.