One traditional defence of active funds has been, appropriately enough, that they should be more defensive in bear markets.

Active managers should after all be able to avoid the most distressed companies in an index, or failing that should at least be able to raise their cash levels and wait patiently for a recovery.

The argument nevertheless invites a fairly simple rebuttal – the average UK equity manager underperformed the FTSE All Share in total-return terms and generated negative risk-adjusted returns in the downturn of 2011, for example – even if it is harder to refute given that past performance is an unreliable guide to the future.

A forthcoming paper in the International Journal of Finance and Economics by Jason Foran and Niall O’Sullivan of University College Cork offers a more nuanced assessment of how active managers handle market corrections.

Tin hats at the ready

They investigated whether managers could successfully lower the beta of their portfolios ahead of periods of market volatility and illiquidity, focusing on a time between 1997 and 2009 characterised by such issues.

Their sample was a survivor-bias-free set of over 1,100 actively managed open-ended UK equity funds, including equity income and small-cap mandates alongside the All Companies sector.

The academics examined first whether these managers could simply time the market by increasing their beta when it would have been opportune to do so. A mere 2% were able to do so positively to a statistically significant degree (defined throughout as at the 5% level), but 34% timed the market to negative effect.

‘This preponderance of negative over positive return timing among UK equity mutual funds is consistent with previous UK findings,’ commented Foran and O’Sullivan.

Timing the collapse

They then turned to volatility timing, where managers fared better: 21% lowered their beta in advance of volatile spells. ‘It is noteworthy that the degree of volatility timing ability among funds is higher than that of return timing ability,’ the authors observed.

However, in 11% of the funds beta was actually raised before market volatility struck. ‘Why funds would engage in such a strategy is puzzling,’ Foran and O’Sullivan remarked.

Finally, they looked at whether managers could time collapses in market liquidity: 10.8% of the funds did so successfully, but again a large proportion – 22.5% – ‘counter-intuitively’ increased their portfolio beta before periods of above-average market illiquidity.

Whether the ability to time volatility and illiquidity boosts a fund’s performance is a different question, but the answer is no more comforting for active managers.

Theoretically, of course, it should: higher volatility and lower liquidity have both historically been correlated with lower returns, so managers who minimise beta ahead of such periods should do well.

Yet there was little evidence of this in practice. The top decile of liquidity timers did not go on to yield significant positive alpha, although the bottom decile did suffer statistically significant negative alpha.

‘It appears that investors seeking fund abnormal performance should at least avoid poor market liquidity timing funds,’ summarised Foran and O’Sullivan.

With volatility, the best timers ‘perversely’ ended up with negative excess returns.

Quid pro quo

‘This result provides prima facie evidence that funds that are successful at anticipating market volatility by reducing the fund beta in advance of higher market volatility do so at the expense of successful security selection,’ the researchers concluded.

One silver lining to these storm clouds for active funds may be that Foran and O’Sullivan also documented no persistency in timing either market volatility or illiquidity, so even though these managers struggled in the last crisis there’s no guarantee they will do so again during the next one.