Indices based on factors such as low volatility and quality generally feature defensive characteristics. These strategies tend to outperform the broad benchmark in down markets, as previous studies have shown. However, some market participants also believe that active management fares somewhat better than the benchmark in periods of volatility and distress. In 2018, the S&P 500® rallied 10.56% in the first three quarters and lost 13.52% in the fourth; this provides a good test to compare actively managed mutual funds against passive defensive factor strategies and see which rode the rollercoaster better. In our test, we also include the S&P 500 Equal Weight Index.
Different factors deliver different investment results, due to unique defensive mechanisms. In 2018, low volatility and dividends outperformed while quality lagged, compared with the median performance of all largecap mutual funds. Over the long term, when the cyclicality of the market had smoothed out, all these passive strategies tended to outperform the majority of actively managed mutual funds (see Exhibit 1).
In 2018, 64% of large-cap active funds underperformed the broad market, but even more managers underperformed the S&P 500 Low Volatility Index (88%) and the S&P 500 Dividend Aristocrats® (73%). Though quality has been considered a defensive factor, it did not perform as well as low volatility or dividends in 2018. Nearly 56% of active large-cap managers beat the S&P 500 Quality Index over the one-year period.
In the five-year period ending December 2018, the S&P 500 Low Volatility Index and S&P 500 Dividend Aristocrats outperformed over 85% of largecap active managers. In addition, over 66% of active large-cap funds had lower returns than the S&P 500 Equal Weight Index and the S&P 500 Quality Index.
Over the longer-term 15-year period, all four factor indices outperformed more than 98% of the large-cap mutual funds. This is not surprising; these defensive factor indices have tended to have higher hit rates and excess returns in down markets (see Exhibit 2).
