Do Active Funds Perform Better In Down Markets?- New Evidence from Cross-Sectional Study

As discussed in Gruber (1996), the dramatic growth of actively managed funds constitutes a major puzzle in the finance literature. Despite the large amount of money invested in actively managed funds, these funds on average underperform their passive counterparts after fees. The existing literature proposes a potential explanation to the puzzle- active funds perform better in down markets when it matters the most to investors. However, empirical conclusions are hard to draw due to the short time series of data relative to the length of a business cycle. In this paper, we exploit the large panel of mutual fund data, and study the cross-sectional variation in performance cyclicality. Using data from 1980-2008, we find that the most active funds outperform the least active ones by 4.5 percent to 6.1 percent per year in down markets after adjusting for risk and expenses. On the other hand, the most active funds do not outperform in the up markets. A further investigation of the sources of fund performance suggests that active funds show better stock picking skills in the down markets. The results are robust to different measures of fund activeness and definitions of up and down markets. JEL classification: G1