Q:  When the market goes down, index funds will go down right along with it.  Shouldn’t we look to active managers to protect us during a downturn?

A:  It is a common misconception that skilled active investors can anticipate bear markets, and take precautionary actions to prevent losses in a market downturn.  Despite the chatter about active investors’ ability to pick superior stocks in a bear market (e.g., favoring larger, defensive companies in a recession), hold more cash, time the market (buy on dips, sell on tops) or sell stocks short (to profit from price declines) active managers, collectively, have not demonstrated an ability to beat index investors during these periods of market stress.

In 2001, analysts at Schwab’s Center for Investment Research compared the performance record of 120 index funds and 2,100 actively-managed mutual funds.[i] After analyzing these funds’ performance during market declines occurring between December 1986 and March 2001, the researchers concluded:

  • Index funds outperformed actively managed funds in 55% of the down markets.
  • In the worst downturns, defined as declines of 10% or more, index funds outperformed actively managed funds 75% of the time.
  • In the longest downturns, defined as declines of 5 consecutive months or longer, index funds outperformed actively managed funds 100% of the time.

 

In the recent Global Financial Crisis, results were similar.  According to mutual fund database Morningstar, the Dow Jones U.S. Total Stock Market Index beat more than 60% of actively-managed U.S. stock funds from November 2007 through December 2008.

The implication of this data is clear:  Index funds minimize the risk of having an actively-managed fund turn a bad year into a horrible one.   While it might sound logical and alluring to employ an active manager to “do something” in the face of uncertain markets, the evidence resoundingly supports the efficacy of an index fund approach.

i Schwab Center for Investment Research. “Index or Actively Managed Equity Mutual Funds: Which Way to Go In A Down Market,” July 2001.