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Index Funds Work in Bull and Bear Markets

In reply to our recent discussion of index funds and management risk, I received an email that began with the following assertion:

“The problem with indexing is that it only works in bull markets. Active management will outperform when the market moves down.”

The email went on from there to make other questionable arguments, but I wanted to tackle this one because a) I hear it relatively often and b) it’s demonstrably false. (More precisely, the second part of the assertion is demonstrably false. The first part naturally depends on what exactly the writer means by “works.”)

As Nobel Prize winning economist William Sharpe pointed out twenty years ago in “The Arithmetic of Active Management,” after accounting for costs, the average passively managed dollar in a market will by definition outperform the average actively managed dollar in that market.

It Works Like This…

By definition, passive investors hold the market portfolio. That is, they hold each stock in proportion to its market value. So if, for example, Apple currently makes up 2% of the total value of the U.S. stock market, a passive investor will allocate 2% of his/her U.S. stock portfolio to Apple.

Therefore, active investors must as a group hold the market portfolio as well. That is, if one active investor has chosen to underweight Apple relative to its market valuation, that’s only possible because another active investor has chosen to overweight Apple.

Conclusion Part 1: Before considering costs, each passive investor will earn the market return (because he/she holds the market portfolio). Similarly, before considering costs, active investors will as a group earn the market return (because, as a group, they hold the market portfolio).

Conclusion Part 2: After considering costs, each passive investor will earn the market return, minus whatever they pay in investment costs (say, 0.2% for a decent index fund). And, after considering costs, active investors will as a group earn the market return, minus whatever they pay in investment costs (sales loads, brokerage commissions, actively managed fund expenses, etc.).

Conclusion Part 3: Because active investors pay significantly higher costs than passive investors, they must earn a lower average return per dollar invested.

Takeaway: For each portion of your portfolio (U.S. stocks, international stocks, bonds, etc.) if you invest in a low-cost index fund, you will outperform the average actively managed dollar for that category of investment.

It’s Mathematical Certainty

There are very few things in the field of investing that can be said with certainty. But this is one of them. It holds true in every market. And it holds true over every period of time, regardless of whether that period is a bull market or a bear market and regardless of whether that period is a day or a decade.

It doesn’t depend on market efficiency. And it doesn’t depend on active fund managers making stupid decisions. All it depends on is plain, simple math. (John Bogle calls it the “relentless rules of humble arithmetic.”)

Picking Mutual Funds

Of course, due to the sheer number of funds in existence, there will always be plenty of funds that outperform their index over any particular period. (The shorter the period, the more outperforming funds there will usually be.)

But as the Standard & Poor’s Indices Versus Active scorecards have been showing us for several years now, most actively managed funds do not manage to beat their benchmarks–even during bear markets.

And there’s an abundance of data showing that sticking with low-cost funds is a winning strategy. As Russel Kinnel (Morningstar’s Director of Mutual Fund Research) puts it, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. … They are still the most dependable predictor of performance.”

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Comments

  1. One thing that contributes to the mistaken belief that active management outperforms in down markets is due to poor or inappropriate benchmarking. Many active funds hold 5% to 10% cash to trade with and meet redemptions. So when only 90% of your high expense portfolio is down, it can appear better then the whole thing going down. But you really need to compare that to a 90% index/10% cash portfolio to be an apples-to-apples comparison. Aggregately, an when properly measured, the math pointed out in the post causes low cost indexing to win out in any market.

  2. Oblivious Investor-

    Great article. Thanks for taking it upon yourself to address this. I recently saw a similar argument on Schwab’s website here: http://www.schwab.com/public/schwab/research_strategies/market_insight/investing_strategies/mutual_funds/active_funds_vs_index_funds_what_you_need_to_know.html

    I’m curious what your thoughts are on Schwab’s assertions.

    Thanks,

    ssr

  3. Dylan: Good point, thank you for bringing it up. 🙂

    ssr: As discussed here, I inherently distrust most information coming from brokerage firms or fund companies. This is no exception.

    And it looks like a pretty weak case, frankly. They allowed themselves the chance to cherry-pick periods, and over the 4 periods shown, an all-index investor still would have beaten an all-active investor who earned the return of the average active fund.

    So unless you can predict such “momentum markets” and their ensuing end-points, or unless you have a successful method for predicting which active funds will be above average, there doesn’t appear to be much benefit of pursuing active funds.

    As the article itself states, “active management is a zero-sum game.” (And that’s before considering costs.)

  4. Thanks for your thoughts Mike. It’s very strange indeed that the first time period they use is about 3 years, the second about 1.5 yrs, third 1.5 yrs, and the last is only a 4 month period. Definitely seems like cherry picking.

    Plus, what’s up with statements like “In categories such as bonds, active funds may provide more diversification.” They don’t even provide any evidence for this statement. Pretty pathetic.

    The investing media is full of hyperbole and myth, thanks for providing one of the few independent resources that’s evidence based.

  5. Very good article. I always hate it when articles spread mis-information on passive investing. However, I do like to nitpick a bit.
    The S&P scorecard is rather biased since S&P make money from licensing their indexes. They compare active funds, after fees, to the pure index returns, but even index funds have fees. In some markets, Canada for example, even index funds charge >1% MER. Also, some people have access to extremely low fee active funds through their employer’s 401k. I wish S&P would publish the average active fund fees for a true comparison.
    My second point is that actively managed money here refers to ALL active market participants, not just mutual funds. In some undeveloped markets, it is possible that the “smart” investors (i.e. institutions and mutual funds) make up a small portion of the market, while “dumb” investors who treat the market as a casino make up the majority. If such a market exists, then active funds can, on average, beat passive funds. (I’m thinking China here, but I don’t have real data).

  6. Two good points, Lisa.

    Your second point is the reason that I tried to make a point of saying that the average passively invested dollar will outperform the average actively invested dollar, rather than saying that it would outperform the average dollar invested in actively managed funds. Your comment however, makes me suspect that I made a misstatement at some point that I can’t seem to spot. (?)

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