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taking stock

Even when a large swath of Europe was tumbling into recession, China was slowing and the U.S. was marching ever closer to the edge of a growth-crushing fiscal cliff, equity investors took heart from the fact plenty of big corporations were still figuring out ways to goose profits, boost market share and beat estimates. But tougher times are inevitably taking a toll.

It isn't exactly a rout, but disappointing third-quarter results from such bellwether names as Caterpillar, General Electric, Dupont and McDonald's certainly heightened market angst last week. More worrisome than weaker earnings was the flattening out of revenues. As estimable market strategist Ed Yardeni noted: "If revenue growth turns negative and margins turn down, the bull market is kaput." Mr. Yardeni doesn't buy that bearish view of the world – he sees top-line growth resuming in coming quarters, in line with continued U.S. and global economic expansion.

But if the European debt crisis deepens, China's landing turns out to be a lot harder than forecast and U.S. politicians somehow walk off that fiscal cliff on Jan. 1 – all plausible outcomes, based on past performance – the world would most certainly slide back into economic quicksand.

For the hardy souls who have resisted the urge to flee the markets, those relying on active money managers to keep them safe from the coming storms can take heart from the fact these folks tend to provide more protection in bear markets than typical passive investments. The reason: Active managers can play better defence, pulling money off the table or shifting it to other assets and taking advantage of market-timing – moves not available to passive funds.

But now along comes a U.S. study that shatters yet another market myth.

Active managers do have a better track record in recessions, but the study concludes that "active portfolio management fails to add value above the higher costs it imposes on investors."

Some managers do beat the market, "but not enough to pass anything on to the investor," says U.S. financial adviser Harold Evensky, co-author of the report, which sifted through two decades of mutual fund performance in both rising and falling markets. The study, which appears in the latest issue of Journal of Investing, used an industry average fee in the U.S. as a yardstick (Canadian costs tend to be higher). But even if fees were half the average, it would still leave the question of whether the manager could sustain a good performance over time.

The fact is that those who did well during a particular market slump were unable to carry their success over to the next phase of the cycle or even later downturns. "The fact that they did well in one bear market didn't necessarily mean they'd do well in the next bear market," Mr. Evensky says from his office in Coral Gables, Fla. "Yes, they added it [value] this time around. But is there any reason to believe they're going to add it next time around? The answer is, probably not."

The study examined a broad universe of funds. "We didn't say that there might not be some manager who could consistently add value," says Mr. Evensky, a 35-year industry veteran who also teaches a graduate investment class at Texas Tech University. "But it certainly suggests they would be awfully hard to find, and you probably wouldn't know it for a decade [of performance]."

Yet for all that, Mr. Evensky remains agnostic about the whole passive against active debate. "In our practice, in the equity market, we think the passive wins maybe 80 per cent of the time. But there are a few instances in which we use active [managers]."

He looks for the worst performers in the past one to three years, not because of poor management but because their particular styles or sectors of activity have been getting hammered. "I very much believe in a regression back to more normal historical patterns. That's one of the criteria I use for what looks interesting." So when fund marketers come calling, he's not interested in their five-star performers, but in the well-managed funds that have simply been in the wrong place at the wrong time.

Asked about where he thinks the market is headed, he notes that his firm's investment decisions for clients are based on a long-term view of the markets. "We have an underlying belief that over time, the domestic and world economies will go up and stocks will earn more than bonds. That is a fundamental premise of our practice."

Nevertheless, he acknowledges that in the short term, "the market is exposed to quite a number of potential negative hits." At the top of his worry list is the fiscal cliff, because the tax hikes and deep spending cuts that would be triggered automatically if there is no political compromise by the Jan. 1 deadline would almost certainly plunge the U.S. into recession.

His main message to investors is to set aside funds needed for expenses in the next five years in cash or short-term bonds and avoid selling stocks into a panic. To that end, "we spend time educating clients and holding their belts and suspenders when everyone else is jumping out the window."