Why Mutual Fund Managers Cannot Protect Investors In Bear Markets

Over my 27 years in the business, I often discuss bull and bear markets with investors. A couple of popular beliefs frequently surprise me.

The first is that bear markets are rare events. Investors are still surprised, some even shocked, that two bear markets, 2000-2003 and 2007-2009, took place within a nine-year period. Yet there have been 25 bear markets over the last 113 years, or one on average of every 4.5 years.

So in fact, the last two bear markets arrived just about on that historical average. The abnormal 1990’s bull market, which lasted for a record ten years, probably tricked many into assuming that such endurance is typical of bull markets.

The other belief that often surprises me is the expectation that holding investments in managed mutual funds (as opposed to non-managed index funds) provides protection against losses in bear markets.

Investors realize that if they hold a market index fund through a bear market they will experience whatever drawdown or loss the market experiences. However, many believe if they hold a managed mutual fund through a downturn, the fund’s manager will take steps to protect them from loss. Moreover, that if he does not, he is not doing his job.

However, the facts are that if a fund manager is doing his job, he or she probably cannot do much to protect the fund against bear market losses. That is because fund managers are quite limited in how far they can go in re-allocating assets even when they determine the market is at high risk of a substantial downturn.

They can buy and sell stocks, taking profits (and losses) and moving on to different holdings. In fact, investors would probably be surprised that, while mutual funds advise investors to simply buy and hold, that is not how they manage their funds. Studies by fund-tracking service Morningstar Inc. show that the average turnover rate for managed mutual fund portfolios is 85% annually. That is, on average they hold 85% of the stocks in their fund’s portfolio for less than 12 months.

When expecting a market correction or bear market, they can therefore protect their portfolios to some small degree by selling riskier stocks and buying defensive-type stocks that are not likely to decline as much in a correction.

However, they cannot move substantially into cash in times of high risk, or hedge with downside positions or short-sales. In accordance with the restrictions imposed by their prospectus (I know, who reads those), they must remain pretty much fully invested at all times.

They must also remain pretty much fully invested in whatever is the strategy spelled out in their prospectus and advertising. That is a growth fund must remain invested in growth stocks, a value fund in value stocks, a technology fund in technology stocks, and so on.

Why do the prospectuses of mutual funds require that the fund remain fully invested at all times, even when its manager believes the overall market is in for a significant decline?

Because investors, and particularly money-management firms utilizing the fund, need to know that if they want to be, for instance 60% in stocks, and 40% in bonds, that when they invest 60% of their assets in a stock mutual fund the fund will remain 100% invested in the market.

If the mutual fund manager were to decide market risk is too high, and move the fund to for instance, only 50% invested, 50% cash, those money-managers and their investors who want to be 60% in stocks would unknowingly be only 30% in stocks. Similarly, if an investor wants to be 30% in the tech sector or the financial sector, he must be confident that the mutual fund has not deviated from its mandate.

So even in serious market declines, even if the fund manager would rather not be, his fund must remain fully invested.

Therefore, it is important for investors to realize that whether in an index fund or a managed fund, any changes in exposure they may feel the need for, any risk management they envisage, is on them. The mutual fund manager will not take care of that for them.

As we approach the end of the market’s favorable winter season, with the market over-valued by most measurements, and the Federal Reserve rapidly tapering back the QE stimulus that has been so important to the five-year bull market, this might be a time to make plans regarding risk management, as in being prepared. It does not usually work to wait until a serious downturn is well underway before beginning to think about how to handle it. That approach tends to add to the statistics showing that many investors hold on all the way down, only then exiting near the bottom in disgust, maximizing losses and missing out on much of the next bull market.

Food for thought.

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Sy is president of StreetSmartReport.com and editor of the free market blog Street Smart Post. Follow him on twitter @streetsmartpost. He was the Timer Digest #1 Gold Timer for 2012 (Gold Timer of the Year), as well as the #2 Long-Term Stock Market Timer.