Active vs. Passive: Which strategy wins in a bear market?

Today, we will discuss which strategy works better in falling markets—active or passive and what investors should do.

The News

The Nifty 50 marked over 10% fall from its all-time highs in November last year. Thereafter, it showed some recovery, but it has fallen again now.

Seeing the market volatility, one of our readers asked an interesting question—which mutual fund category performs better in falling markets, active or passive funds?

So today, let’s look at some data points and see how this debate of active vs. passive funds holds in falling markets.

Why does active vs. passive debate matter?

Recent trends indicate a decline in outperformance for active mutual funds, showing a sharp rise in the assets under management of passive funds

This shift highlights the need to rethink the pros and cons of both strategies, especially during bear markets.

Active management is based on the assumption that skilled fund managers can exploit market imperfections to deliver better-than-benchmark returns. However, empirical evidence is mixed.

The SPIVA Global Mid-Year 2024 Scorecard suggests that active managers had an extremely difficult half-year in 2024 since only a handful of large-cap stocks dominated the upside in benchmark returns.

For instance: 77% of Indian large-cap active funds underperformed the S&P India Large-Mid Cap’s total return of 17.4% (mid-year 2024). Mid- and small-cap active funds showed marginally improved results, with 52% underperforming the S&P India SmallCap’s total return of 22.3%.

Navigating Bear Markets: Who Wins?

Historically, active funds have outperformed indices during broad-based market rallies, leveraging their diversified portfolios.

Conversely, in narrow market movements or bear markets, their performance is mixed. In some bearish years, they beat the index, but often they lose much more than the index.

For example, during the volatile first half of 2020, the Nifty 100 index declined by nearly 15%, reflecting the broader market downturn.

In this period, 45.16% of active large-cap funds underperformed the benchmark. It highlights the difficulty of achieving consistent success in bear markets.

Similarly, 43.14% of mutual funds in the Mid-cap and Small-cap categories underperformed their benchmark index.

The Verdict: Active or Passive?

The decision between active and passive funds depends on factors like market conditions, investor objectives, and willingness to accept risk.

Active funds can readily adapt to changing markets, taking advantage of opportunities when volatility strikes. This flexibility has a higher cost and may not guarantee outperformance.

While passive funds are inexpensive vehicles through which one can gain exposure to market trends, they may expose investors to sector-specific risks in more turbulent markets.

To Conclude

It might be wise for investors navigating bear markets to balance out the approach by diversifying between active and passive strategies and obtaining the benefits of both worlds: the alpha-generating potential and the stability that comes from broad market exposure.

Ultimately, aligning investment choices with long-term goals and market conditions is key to optimizing outcomes in any market phase.