A rising tide may float all boats but a rapidly receding one offer its own opportunities too; for institutional investors, it provides the chance to find out which funds really are properly clad in swimming wear.

For active fund managers, it's a moment of truth: can they walk the walk?

For the past nine years US equity markets have been on a generally upward trend, which has allowed even mediocre funds to boast decent levels of return. That all changed on Thursday, February 1, when the S&P 500 began falling. By the close of the market on Monday, February 5, it had dropped by 6.1%.

Asia’s markets experienced similar falls: Hong Kong’s Hang Seng index fell from 32,712.66 on Friday, February 2 to 30,626.41 at the close of Tuesday, February 6.

So far this market correction appears to have been sharp, but limited. It wasn’t entirely unexpected either; US equities had been looking frothy for a while and fears had been building that interest rate hikes might have to increase by more than projected to quell inflation.  

But while this may prove to have been an unpleasant but limited market re-levelling, the sheer size of it should offer some interesting analysis about which active funds managed to outperform a falling market. 

That is becoming an important point for asset owners. Even before this market correction, an analysis of pension fund investments by CEM Benchmarking on behalf of FTfm underscored that institutional investors gain a very small level of additional value on average from many active managers. 

The study revealed that active managers beat the market (and hence passive rivals) by an average of 60 basis points (bp) for pension scheme clients, but that 44bp of this was consumed in fees. This comes on the heels of another news story that many fund managers, including some passive ones, had hidden levels of fees, causing higher costs to end investors than claimed. 

FLAPPING IN THE BREEZE

While pension funds have realised at least some value by selectively choosing active funds, there is evidence that the broader active fund market has often struggled to do better than the market over long time periods (index provider S&P Dow Jones said 99% failed to beat their benchmarks between 2006 to 2016).

The standard defence to this by fund managers is that all funds rise along with the market, but only they can offer better value once it starts to dip or remain range-bound.  

They are about to be judged on the merits of these views. 

A lot of active funds should be able to demonstrate that they offered superior performance when compared to typical passive products such as exchange-traded funds, which faced full exposure to the stock market falls. 

But the question of their relative value becomes a bit more complicated once fee levels are included. Active funds managers that can demonstrate they dropped at a far slower trajectory than their passive peers and saved institutional investors money net of fees will truly burnish their reputations. 

If a large number of active funds can demonstrate such outperformance, it could even reduce the massive shift of assets into passive funds. 

On the other hand, if many active funds fail to demonstrate superior returns once fees are subtracted, asset owners would be well within their rights to question the validity of their operations. 

It will also be interesting to consider the performance of smart beta funds in this new, tumultuous environment. These funds are passive, in that they track an index, but that index focuses on factors such as quality, dividends or momentum instead of pure market capitalisation. 

If some of them can beat their cap-focused cousins as a result of focusing on other measuring factors they will have amply demonstrated their value. Those that fail will face many questions as to the value they provide. 

Perhaps the ultimate test in these topsy-turvy times will be on hedge funds. These have long been maligned by many asset owners as being pricey and poor performing, but the entire purpose of a classical hedge fund is to manage sudden downturns far better than long-only rivals. Those that can demonstrate that they did so could enjoy a return to grace, 2 and 20 fees and all. 

Assuming the early-year stock market slump does not presage a longer downward shift (and the fundamentally decent state of the global economy means that it’s unlikely), asset owners can learn a lot from the global stock market’s February fright. 

It’s never a bad idea to know which fund managers are best prepared for a more prolonged turn in the tide.