The U.S. economy has experienced many extreme economic events over the past 200 years. 

During such times, investment professionals — i.e., asset managers, investment advisers and institutional investment consultants — often claim that greater levels of economic uncertainty provide better odds for active management. 

Financial history, however, demonstrates that such claims are empty.

"The claim that ‘unprecedented times' create more favorable investment environments for active managers is neither new nor substantiated," says Mark J. Higgins, a financial historian and institutional advisor at Index Fund Advisors.  

Supporting this observation, Higgins recounted the performance of investment companies —  which were precursors to modern-day mutual funds — from 1927 to 1935. 

"The U.S. experienced its worst stock market bubble, crash and economic depression during this eight-year period," he says. "Yet active managers, in aggregate, failed to outperform a comparable index of securities."

This is especially disconcerting, adds Higgins, because one could also argue that markets were less efficient at the time. "So, if active managers failed to benefit from macroeconomic uncertainty, then, it seems inconceivable that they will benefit today," he says.

It might seem paradoxical, but Higgins also contends that financial history can help investors envision potential future scenarios with greater clarity. "This is unlikely to enable them to outperform efficient markets," he says, "but it can help calm their nerves and prevent them from acting in ways that compromise their long-term objectives."

As an example, Higgins relates in his book ("Investing in U.S. Financial History: Understanding the Past to Forecast the Future") that even though inflation after the Covid-19 pandemic soared, the experiences — and, more importantly, the underlying causes and the Federal Reserve's reaction — were very similar to those that Americans experienced after the end of World War I and the Great Influenza (1919-1920). Explaining this precedent helped prepare institutional trustees for the possibility that inflation might prove to be more than "transitory," and that the Fed was likely to respond more aggressively than most investors anticipated.² 

This was not the only historical event that helped investors navigate Post-Covid-19 inflation. For instance, understanding the Great Inflation of 1965-1982 is now helping to anticipate the Federal Reserve's responses. Higgins explains: 

"Understanding the Great Inflation enables one to understand why the Federal Reserve is maintaining such tight monetary policy — and will continue to do so until inflation is decisively extinguished. Their failure to decisively extinguish inflation in the late 1960s and early 1970s allowed elevated levels of inflation to become entrenched. The Fed is unlikely to repeat this error."

Despite the value of using financial history to refine one's expectations, Higgins cautions that investors should still resist the temptation to try to outmaneuver efficient markets. Illustrating the difficulty of predicting market outcomes with precision, he recounts a comment made by the former Fed chair, Paul Volcker, during his historic monetary tightening effort that began in October 1979. 

When Volcker was asked a question about whether his ‘draconian' monetary policies would cause a recession, he acknowledged that might be the case. But he also knew that forecasting the timing, magnitude and duration of a recession was impossible — even for the Federal Reserve chairman himself. 

As a result, Volcker responded: "There is a prudent maxim in the economic forecaster's trade that is too often ignored — pick a number or pick a date, but never both." 

Higgins asserts such logic hasn't changed today. "Just because there are precedents that help explain what is happening in the present and narrow the number of scenarios that are likely in the future," he says, "it does not make it possible to predict the future with sufficient accuracy to beat the market." The IFA institutional advisor adds:

"Although it is true that history strongly suggests that the Fed will maintain tight monetary policy longer than people anticipate, and that this will likely cause a recession, it is far from certain. More importantly, even if it does happen, the timing, magnitude, and duration of the recession remains highly uncertain. Therefore, while precedents exist to help demystify the present, this is far from sufficient to make the claim that active management is more advisable in turbulent times."

Higgins concludes that "deepening one's knowledge of financial history is a powerful tool for investors, yet it is almost universally unappreciated."

Contextualizing the present helps steady your nerves during extreme events, he notes. This, in turn, helps investors resist the temptation to react in a manner that compromises their long-term objectives. 

"What it does not do, however, is provide a more attractive opportunity set for active managers," says Higgins. "Those who buy into the latter claim are just as likely to be disappointed during tumultuous times as they are during more tranquil ones." 

Footnotes:

1. Report of the Securities and Exchange Commission, "Investment Trusts and Investment Companies," 1940, Part Two, Appendix J, p 905.
2. Mark J. Higgins, "Investing in U.S. Financial History: Understanding the Past to Forecast the Future," Greenleaf Book Group, 2023.

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