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Half-Truths and Gorilla Dust: Comparing Index Funds and Actively Managed Funds in a Market Decline Thumbnail

Half-Truths and Gorilla Dust: Comparing Index Funds and Actively Managed Funds in a Market Decline

Sometimes evidence just gets in the way of the story we want to tell.

I was scrolling through some news stories on my phone recently and came across an eye-catching headline from Marketwatch: “How Index Funds Mislead Investors.” (The actual web address for the story includes the phrase, “Troubling things index funds won’t tell you.”)

In the story, Conrad De Aenlle provides a summary of “widely respected investment newsletter editor and money manager” James Stack’s recent letter, in which he argues that actively managed mutual funds will offer better protection to investors when the market declines compared to an index fund. According to the article, Stack claims that an active manager can sit on cash to dampen losses and be quicker to sell “losers” that will go down even further, where an index fund by definition will be fully invested (in line with the index it attempts to track) and will continue to hold all of the stocks that make up that index.

This sounds promising. After all, if we can find a way to limit our losses in a market downturn, then the resulting recovery will be that much more beneficial.

Unfortunately, the evidence doesn’t seem to be on Stack’s side. Looking back on the most recent significant market decline in 2008, the Vanguard 500 Index Fund (VFINX) returned -37.02%. If Stack were right, this should be one of the worst performing fund records that year. As it turned out, according to Morningstar, the fund actually returned 0.77% better than the average fund that invested in large US companies. What’s more, VFINX actually had a better return than 62% of the mutual funds that invested in the same category.

Going back over a longer period of time, Vanguard reviewed the six bear markets in the U.S. since 1970 and found that half of the time, active managers failed to outperform the US stock market.[1] Vanguard broke down the analysis even further and categorized actively managed funds by their respective style (e.g., Large Growth, Small Value, etc.) and still failed to find any consistency in actively managed funds beating their benchmarks during market declines.

In fact, Vanguard’s analysis is overly generous to actively managed funds, because they were only able to analyze funds that had survived each of the bear markets that they studied. Funds that were shut down or merged into other funds didn’t show up in their data base. Had those funds been included, it’s likely that the results would have looked much worse.

This doesn’t mean that there weren’t any managers that outperformed their benchmark (or the overall market) during market declines, nor does it mean that there won’t be managers who outperform an index in the next market downturn. And Stack’s arguments about why active management could help in a declining market may even be true.

But the inherent problem with actively managed funds is identifying which manager is going to consistently protect you/outperform and which one is going to perform just as badly – if not worse – than his or her benchmark. The core of Woodward Financial Advisors’ investment philosophy is that this is ultimately a time-wasting and losing proposition, as there isn’t a reliable indicator by which to judge future performance.

So are index fund investors really being misled, or are actively managed funds selling a bill of goods? The data suggests one conclusion, no matter how enticing the alternative story might be.

[1] Phillips, Christopher B. The Active-Passive Debate: Bear Market Performance (2008) https://personal.vanguard.com/pdf/icribm.pdf

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