This article was originally published June 7, 2016.

Funds with Certain Characteristics Have, on Average, Tended to Generate Better Results During Market Turbulence

As in years past, the early days of 2016 found many in the investing community awaiting confirmation of a seemingly unimpeachable truth: the average active manager had once again failed to beat the index.

To their surprise, that confirmation has not been forthcoming.

That’s because, in a year when markets sputtered and tumbled on concerns about China’s future and sinking oil prices, the Wall Street Journal reported that in 2015, actively managed open-ended funds tracked by Morningstar Inc. actually did better than their passive counterparts, losing an average of 2.2% compared to a 2.7% loss for passive funds.

It’s a small difference, to be sure — but it illustrates the potential benefits of active management, particularly in down markets.

“In challenging markets, active managers have tended to do better.”

Rob Lovelace, Capital Group Portfolio Manager

“Solid stock selection can prove its mettle, and the cash in portfolios acts as a cushion. Not to mention the fact that during downturns active managers can invest opportunistically, which can support long-term results,” Lovelace says.

Despite the potential for actively managed funds to add resilience to portfolios, many investors continue to view passive options as a safer choice. A common argument is that, with index funds, they get a certain peace of mind that their portfolios will only drop as far as the index does — eliminating the regrets that can come with trailing a benchmark.

But committing to the market return can have its drawbacks. Full exposure to market downturns adds stress to the portfolios of retirees and those taking income — a risk they may not fully grasp. In a recent survey conducted by opinion research firm APCO Insight, 78% of retirees said that protecting savings and investment gains from market downturns is an important priority. Yet only 53% are aware that investing in index funds exposes them to all the ups and downs of the market.

The all-index-fund path also boxes out actively managed funds with a history of holding up better during downturns, and it fails to account for the fact that such resilience — in combination with other factors — has been instrumental in the return calculus of funds with long-term track records of beating their benchmarks.

Funds With Low Downside Capture Histories Fared Well During Declines

An analysis of large-cap U.S. funds over the past four decades shows how those with a history of low downside capture have done better than those without a similar history during the worst market downturns.

A review of monthly rolling five-year periods in that four-decade time frame shows that, during the market’s 50 worst rolling five-year periods, the quartile of funds with the best downside capture characteristics going into those periods had better results than those of the other quartiles. In those periods, the funds in the best downside capture quartile generated better results than the worst downside capture funds by an average of more than 1.5% annually. Top-quartile funds also fared well across other metrics, including standard deviation, beta and maximum drawdown.

Downside capture ratio compares a fund’s return with an index’s during periods when the index return was negative. In other words, a lower downside capture ratio indicates that the fund did better in declining markets.

Low Downside Capture Is Not Enough

Importantly, the same study revealed that the lowest downside capture quartile did not outpace the broader market, based on the average for all the periods measured. There are, however, other fund characteristics associated with index-beating outcomes, according to recent research by Capital Group.

The study found that over the last 20 years, a group of actively managed equity funds with lower-than-average downside capture and low expense ratios whose managers were heavily invested in the funds they managed, on average, outpaced their respective benchmark indexes. That was true over five- and 10-year time frames as well.

This group of actively managed funds was, on average, able to generate index-beating results during particularly tough times: The test period included the dot-com meltdown in 2000 and the 2008 financial crisis.

“In a common withdrawal scenario, the group generated measurably better results than both the index and the entire active universe by nearly 150 basis points annually, which over the course of a normal retirement can be the difference between success and failure,” says Steve Deschenes, director of product management and analytics for Capital Group.  Even as withdrawals increased in retirement scenarios, this select group of active funds outpaced their benchmarks and peers.

“There’s no reason to settle for average. There’s an opportunity to do better — and substantially better — to create more wealth.”

Steve Deschenes, Capital Group Director of Product Management and Analytics

Visit the American Funds website for related methodology.