In rising markets, a strong majority of actively managed funds lag their market benchmarks, but in down markets almost as many show a remarkable resilience. Since bear markets are inevitable, it can be a worthwhile exercise to identify fund managers and types of strategies that can participate in rising markets while resisting the full impact of market downturns.
To examine bear-market performance in two mainstream domestic categories -- Canadian Equity and Canadian Small/Mid Cap Equity -- we looked at how funds did in five money-losing calendar years: 2001, 2002, 2008, 2011 and 2015. It turns out that 57% of Canadian Equity funds, and 64% of Small/Mid Cap Equity funds did better than their benchmarks.
In seeking to identify the more downturn-resistant funds, we first screened for the top-15 performers during the severe bear-market year of 2008, whose 33% loss for the S&P/TSX Composite Index was the steepest of any of the five most recent calendar years of negative performance. The next step was to identify those funds -- five in all -- that have track records covering the whole period from 2000 to 2016. These five funds beat their index in 2008 by margins ranging from four to 10 percentage points.
One fund, Beutel Goodman Canadian Equity Class D, consistently beat its index in each of the five downturn years. BMO Canadian Equity managed this feat in four out of five years, and two others did so three years out of five.
In the calendar years with positive returns that followed the downturns, the five downturn-resistant funds did not fare very well. A notable deception was 2009, when none beat their index. Only one did so in 2003, and two in 2012 and 2016.
| Best-performing actively managed Canadian equity mutual funds in 2008 | ||||||
| Name | 2001 | 2002 | 2008 | 2011 | 2015 | |
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| Beutel Goodman Canadian Equity Class D | 9.26 | -6.96 | -22.87 | -6.99 | -5.28 | |
| CIBC Canadian Equity Value | -3.80 | -18.66 | -25.78 | -9.63 | -14.43 | |
| Educators Growth | -4.52 | -13.39 | -26.29 | -8.76 | -2.23 | |
| BMO Canadian Equity A | -4.83 | -9.04 | -26.95 | -8.91 | -2.54 | |
| HSBC Canadian Equity Pooled | -12.69 | -10.91 | -28.88 | -9.71 | -4.93 | |
| S&P/TSX Composite | -12.57 | -12.44 | -33.00 | -8.71 | -8.32 | |
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| Source: Morningstar | ||||||
A fund manager's use of cash reserves may be one explanation for beating a market benchmark during down years. "A fund may resist a downturn better only because of its large cash position, not because stocks are providing downside protection," warns Dan Hallett, vice-president and principal at Highview Financial Group, an Ontario investment-counselling firm.
In understanding the role that cash reserves play in capital preservation, the key is to compare the proportion of cash with the proportion by which the fund resists a market decline, says Daniel Dupont, the Toronto-based portfolio manager of Fidelity Canadian Large Cap. For example, he says, if a fund resists a downturn by 5% and has a 15% cash hoard, it is likely that the downward resistance was attributable entirely to cash reserves.
Cash isn't the only reason why some managers can resist downturns, according to Dupont. A value investor, he seeks to buy stocks at a deep discount to their intrinsic value. He favours companies that have strong balance sheets and that are less vulnerable to unpredictable factors such as interest rates, commodity prices, exchange rates and inflation. But since deep-discount stocks are increasingly rare at this point of the market cycle, Dupont is indeed hoarding cash, a whopping proportion of 35%.
The success of the value-style Beutel Goodman Canadian Equity in resisting downturns is attributable to consistent application of its rigorous buy and sell disciplines that are based on discounted free cash flow. The managers seek to invest in stocks whose discount "is sufficient to potentially give a 50% return over three years," explains Mark Thomson, managing director of equities at Beutel, Goodman & Co. Ltd. in Toronto. "We don't base our decision on P/E multiples or any other market-favoured parameter."
Under Beutel's sell discipline, the managers will sell at least one third of their holding in a stock as soon as it reaches the expected return. They will keep the remaining portion only if the stock still promises an attractive return, but nothing is kept that trades at a premium over their assessment of the value of the business.
In managing BMO Canadian Equity, another outperformer in down markets, the approach is "style-neutral," says portfolio manager James Thai of BMO Asset Management Inc. Everything depends on the type of downturn looming on the horizon, he says.
In 2015, the problem was the collapse of oil prices, which Thai had seen coming, though its force surprised him. A future challenge, which Thai expects to hit in the next one to three years, will be related to rising interest rates. That will prompt him to favour "companies that can withstand higher rates, with lower leverage and strong balance sheets, he points out. It's not the entire portfolio that we change, rather (it's) adjustments that we do at the margin."
