I’ve written many times before about the dangers lurking inside Bull Markets (see, e.g., “The Trouble with Bull Markets,” post of 9/12/13, and “More Trouble with Bull Markets,” post of 9/26/13). Here are just a few of the problems:

* During Bull Markets everyone forgets about risk.

* We watch unconcernedly as our equity allocation grows from 65% to 80%, making us fat targets for the looming Bear Market.

* We really, honestly believe that “this time it’s different,” that we’ll get out before the Bear gobbles up our capital.

* We think that if we don’t seize this opportunity to make big money, we’ll be left out in the cold and regret it forever.

* We think we’ve miraculously added a hundred IQ points to our investing intelligence.

And so on and so on. But today – given that the current Bull Market has finally met its bridge abutment – I want to point out another casualty of Bull Markets: active management. It’s as predictable as sunshine in the high desert: toward the end of every Bull Market, all the prognosticators assure us that active management is dead. Investors pile into index funds just in time to get killed.(1)

I don’t care how good a money manager is, he’s going to underperform during a raging Bull Market. In fact, a good definition of a bad manager is somebody who outperforms in a Bull Market (because that manager is happy to subject his clients to excessive risk). Active managers charge fees and they hold cash, if only to meet redemptions. Their trades, even if they rarely buy and sell, cost money. Those trades incur taxes. Benchmarks incur none of this, or very little, and index funds aren’t far behind.

Therefore, what happens near the tail end of a long Bull Market is that the usual statistics that demonstrate how good an active manager is begin to deteriorate. I don’t mean just its underperformance against a crazy, government-induced Bull Market. I mean all the manager’s statistics. Consider any good value or growth-at-a-price manager:

* By the end of the Bull Market, its downside capture(2) looks lousy. This isn’t because the manager suddenly got stupid, but because the market suddenly got stupid. Stocks that are underpriced versus other stocks, and that would normally hold up well in a market drawdown, actually don’t always hold up well in a brain-dead, buy-on-the-dips Bull Market. In other words, stocks that should do well in a drawdown don’t, and the manager’s downside capture looks lousy. This isn’t a this-guys-sucks-as-a-manager problem, this is a-Bull Markets-make-us-all-stupid problem. In other words, the manager’s downside capture looks bad, but it really isn’t. When markets eventually get back to normal – even the Fed, addicted as it is, will eventually have to stop pumping up stock prices – the stocks our manager owns will do quite well in downdrafts, thank you. So we have to ask ourselves, do we want to be with a manager whose downside capture looks bad during those very rare periods when markets are being manipulated by government agencies, or do we want to be with a manager whose downside capture looks bad during the great many more-normal markets we are going to encounter over our investment lifetime? The question answers itself, you would think, but almost everyone gets it wrong.

* The manager’s Sharpe ratio(3) looks bad. This sounds terrible, since you don’t normally want to be with a manager whose performance looks bad on a risk-adjusted basis. But keep in mind that the risk-adjusting calculations are coming against a totally screwy market that looks like it’s a low-risk proposition but actually isn’t. Volatility has been artificially reduced by the Fed, making our manager look bad. But vol will have its way soon enough, and quite suddenly our manager’s Sharpe ratio will look terrific. Except that by then most investors will have bailed out of the manager and into index funds. Somebody is going to get killed when the market turns, and the question is, where do we want to be when the bloodletting starts?

So here we have a manager whose performance looks crappy against its benchmark, whose downside capture looks bad, and whose Sharpe ratio has collapsed. Under ordinary circumstances, we wouldn’t want anything to do with such a manager. But when those statistics are being generated against a raging Bull Market, we need to disregard them and look at the manager’s longer term track record. Otherwise, we’re behaving as stupidly as the market.

(1) Charley Ellis is an especially good contrary indicator, since he has developed a knack for piling onto a trend just as it’s about to end. The best example was his book, Capital: The Story of Long Term Investment Excellence, lionizing The Capital Group at the precise moment that the firm had declined into mediocrity. Now Charley has published “The Rise and Fall of Performance Investing” in the Financial Analyst’s Journal, a certain sign that it’s high time to dump your cap-weighted, momentum-driven index fund and marry up with one of the active managers whose demise Charley has very much exaggerated.

(2) Downside capture measures the degree to which a fund declines as its benchmark declines. In a perfect world a manager would have greater-than-100% up capture (if the market’s up 10%, the manager’s up, say 12%) and less-than-100% down capture (if the market’s down 10%, the manager’s down, say, 8%). Technically, downside capture is measured by taking the fund’s monthly return during the periods of negative benchmark performance and dividing it by the benchmark return.

(3) Sharpe ratio is a measure of risk-adjusted performance, using standard deviation and excess return as the component calculations. Note that a fund can underperform its benchmark and still have a positive Sharpe ratio if the fund is taking much less risk than its benchmark.

Next up: The Paradox at the Heart of the Central Bankers’ Dilemma

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.

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