Indexing Misleads Investors: Do Active Investors Have an Edge in Bear Markets?

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Indexing Misleads Investors: Do Active Investors Have an Edge in Bear Markets?

Larry Swedroe headshot
Wall Street and the financial media alike want and need investors to believe the many myths surrounding active management. And they go to great lengths concocting stories to perpetuate that belief. A good example of such a story is a December 2014 MarketWatch article entitled “How Index Funds Mislead Investors.”
The sub-headline to the article is “Market Veteran Gives Stockpickers the Edge in a Downturn.” The author, Conrad de Aenlle, asked two questions:
  • Is too much money indexed?
  • Does the fact that so much money is now indexed actually increase the odds that shareholders will face steeper losses in the next bear market than if they owned actively managed funds?

Aenlle quotes James Stack, a “widely respected investment newsletter editor and money manager,” who says the answer is probably yes to both questions. Stack warned that so much stock indexing “can raise market volatility, reduce portfolio diversification and exacerbate losses in a protracted decline.” The problem, as Stack sees it, is that the advantages of index funds on the way up become serious drawbacks when the market reverses course.

The article continues: “Index funds tend to do especially well in bull markets, Stack says, because they remain fully invested, while cash holdings in active funds drag down performance. In a decline, the cash in active funds limit losses, especially as it deepens and managers dump more of their positions.”

Luckily, it’s easy to expose the above statements and warnings as false. Let’s take them one at a time. We’ll begin with the assertion that the increase in indexing has raised volatility. There’s simply no evidence to support that argument. The first index fund was introduced by Vanguard in 1977. Prior to that time, the annual standard deviation of the market was above 22. Since 1977, it’s been under 17. As indexing has gained popularity over the past 20 years, it’s been under 18. And in last 10 years, it’s been about 17. This just represents yet another example of commentators making statements that just aren’t true. Fortunately, accountability ruins the game.

Second, indexing has absolutely no impact on diversification. That statement is just rubbish. By accepting market prices, index investors simply allocate capital in the same way that capital was already allocated.

Third, Stack makes the often-heard claim that indexing does well in bull markets, but not bear markets. All it takes is a bit of basic math to disprove that statement. William Sharpe, in his short but brilliant paper, “The Arithmetic of Active Management,” clearly demonstrates that, properly measured, active management cannot win in aggregate. And it doesn’t matter whether the bull is rampaging, the bear has emerged from hibernation, markets are efficient or inefficient, or markets are quiet or volatile. If Sharpe’s simple proof isn’t enough to convince you the conventional wisdom that active managers outperform in bear markets is a myth, perhaps the facts should.

Active Managers Underperform

There are many studies on the performance of active managers in bear markets, and they all come to the same overwhelming conclusion—active managers underperform just as badly, if not more so. The following is evidence from four studies on the issue.
  • Lipper Analytical Services studied the six market corrections (defined as a drop of at least 10 percent) from Aug. 31, 1978, to Oct. 11, 1990, and found that while the average loss for the S&P was 15.12 percent, the average loss for large-cap growth funds was 17.04 percent. That difference is larger than the long-term difference, meaning that active managers actually did worse in bear markets than in bull markets.
  • Goldman Sachs studied mutual fund cash holdings from 1970 to 1989 and found that mutual fund managers miscalled all nine major turning points. You couldn’t get all nine turning points wrong if you tried!
  • Defining a bear market as a loss of at least 10 percent, Vanguard studied the performance of active managers for the period from 1970 through 2008. The period included seven bear markets in the U.S. and six in Europe. After adjusting for risk (exposure to different asset classes), Vanguard concluded that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome. They also confirmed that past success in overcoming this hurdle does not ensure future success.” Vanguard reached this conclusion despite the fact that the data was biased in favor of active managers because it contained survivorship bias.
  • In its 2008 Indices Versus Active (SPIVA) scorecard, Standard & Poor’s concluded: “The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes.”
  • In other words, just as proved by Sharpe’s math, while indexing guarantees that you will experience all of the market’s losses, active investors, in aggregate, will experience even greater ones.

And finally, we need to address another of the article’s warnings: “With index funds accounting for so much of new investment, how soon will it be before they become so dominant that effectively no one is setting prices for stocks beyond a minority of active managers, day traders, computer algorithms and investment bank proprietary trading desks? That could mean prices being determined even more by momentum and less by intrinsic value based on economic and corporate fundamentals.”

First of all, we are still a very long way from that day. Currently, only about 15 percent of individual assets and about 40 percent of institutional assets are indexed. And perhaps 1 percent of assets are shifting each year. Secondly, despite the growing trend toward passive investing, the amount of trading continues to set records. In other words, the remaining active traders are becoming more active, keeping the market efficient at setting prices. Third, you don’t need that many informed investors to keep the market informationally efficient. We certainly don’t need the 7,000 or so mutual funds and the 10,000 or so hedge funds that exist today to do so.

A great tragedy is that, despite its importance, our education system has totally failed the public when it comes to investing. Unless you have an MBA in finance, it’s likely you have never taken even a single course in capital markets theory. And that leaves you susceptible to the lies of Wall Street and the financial media, both of which need to keep alive the myth that active investing is the winning strategy because it’s the winning strategy for them.

The Bottom Line

In 1998, Charles Ellis wrote the wonderful book, “Winning the Loser’s Game.” He referred to active management as the loser’s game because while it’s possible to win (just as it is at the roulette wheel or the craps table in Las Vegas), the odds of doing so are so poor you shouldn’t even try. Thus, the surest way to win the loser’s game is to not play, be it at the roulette wheel, the craps table or active investing.
Larry Swedroe is director of research for The BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. He has authored or co-authored 14 books, including his most recent, The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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Larry Swedroe headshot

Indexing Misleads Investors: Do Active Investors Have an Edge in Bear Markets?

Wall Street and the financial media alike want and need investors to believe the many myths surrounding active management. And they go to great lengths concocting stories to perpetuate that belief. A good example of such a story is a December 2014 MarketWatch article entitled “How Index Funds Mislead Investors.”
The sub-headline to the article is “Market Veteran Gives Stockpickers the Edge in a Downturn.” The author, Conrad de Aenlle, asked two questions:
  • Is too much money indexed?
  • Does the fact that so much money is now indexed actually increase the odds that shareholders will face steeper losses in the next bear market than if they owned actively managed funds?

Aenlle quotes James Stack, a “widely respected investment newsletter editor and money manager,” who says the answer is probably yes to both questions. Stack warned that so much stock indexing “can raise market volatility, reduce portfolio diversification and exacerbate losses in a protracted decline.” The problem, as Stack sees it, is that the advantages of index funds on the way up become serious drawbacks when the market reverses course.

The article continues: “Index funds tend to do especially well in bull markets, Stack says, because they remain fully invested, while cash holdings in active funds drag down performance. In a decline, the cash in active funds limit losses, especially as it deepens and managers dump more of their positions.”

Luckily, it’s easy to expose the above statements and warnings as false. Let’s take them one at a time. We’ll begin with the assertion that the increase in indexing has raised volatility. There’s simply no evidence to support that argument. The first index fund was introduced by Vanguard in 1977. Prior to that time, the annual standard deviation of the market was above 22. Since 1977, it’s been under 17. As indexing has gained popularity over the past 20 years, it’s been under 18. And in last 10 years, it’s been about 17. This just represents yet another example of commentators making statements that just aren’t true. Fortunately, accountability ruins the game.

Second, indexing has absolutely no impact on diversification. That statement is just rubbish. By accepting market prices, index investors simply allocate capital in the same way that capital was already allocated.

Third, Stack makes the often-heard claim that indexing does well in bull markets, but not bear markets. All it takes is a bit of basic math to disprove that statement. William Sharpe, in his short but brilliant paper, “The Arithmetic of Active Management,” clearly demonstrates that, properly measured, active management cannot win in aggregate. And it doesn’t matter whether the bull is rampaging, the bear has emerged from hibernation, markets are efficient or inefficient, or markets are quiet or volatile. If Sharpe’s simple proof isn’t enough to convince you the conventional wisdom that active managers outperform in bear markets is a myth, perhaps the facts should.

Active Managers Underperform

There are many studies on the performance of active managers in bear markets, and they all come to the same overwhelming conclusion—active managers underperform just as badly, if not more so. The following is evidence from four studies on the issue.
  • Lipper Analytical Services studied the six market corrections (defined as a drop of at least 10 percent) from Aug. 31, 1978, to Oct. 11, 1990, and found that while the average loss for the S&P was 15.12 percent, the average loss for large-cap growth funds was 17.04 percent. That difference is larger than the long-term difference, meaning that active managers actually did worse in bear markets than in bull markets.
  • Goldman Sachs studied mutual fund cash holdings from 1970 to 1989 and found that mutual fund managers miscalled all nine major turning points. You couldn’t get all nine turning points wrong if you tried!
  • Defining a bear market as a loss of at least 10 percent, Vanguard studied the performance of active managers for the period from 1970 through 2008. The period included seven bear markets in the U.S. and six in Europe. After adjusting for risk (exposure to different asset classes), Vanguard concluded that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome. They also confirmed that past success in overcoming this hurdle does not ensure future success.” Vanguard reached this conclusion despite the fact that the data was biased in favor of active managers because it contained survivorship bias.
  • In its 2008 Indices Versus Active (SPIVA) scorecard, Standard & Poor’s concluded: “The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes.”
  • In other words, just as proved by Sharpe’s math, while indexing guarantees that you will experience all of the market’s losses, active investors, in aggregate, will experience even greater ones.

And finally, we need to address another of the article’s warnings: “With index funds accounting for so much of new investment, how soon will it be before they become so dominant that effectively no one is setting prices for stocks beyond a minority of active managers, day traders, computer algorithms and investment bank proprietary trading desks? That could mean prices being determined even more by momentum and less by intrinsic value based on economic and corporate fundamentals.”

First of all, we are still a very long way from that day. Currently, only about 15 percent of individual assets and about 40 percent of institutional assets are indexed. And perhaps 1 percent of assets are shifting each year. Secondly, despite the growing trend toward passive investing, the amount of trading continues to set records. In other words, the remaining active traders are becoming more active, keeping the market efficient at setting prices. Third, you don’t need that many informed investors to keep the market informationally efficient. We certainly don’t need the 7,000 or so mutual funds and the 10,000 or so hedge funds that exist today to do so.

A great tragedy is that, despite its importance, our education system has totally failed the public when it comes to investing. Unless you have an MBA in finance, it’s likely you have never taken even a single course in capital markets theory. And that leaves you susceptible to the lies of Wall Street and the financial media, both of which need to keep alive the myth that active investing is the winning strategy because it’s the winning strategy for them.

The Bottom Line

In 1998, Charles Ellis wrote the wonderful book, “Winning the Loser’s Game.” He referred to active management as the loser’s game because while it’s possible to win (just as it is at the roulette wheel or the craps table in Las Vegas), the odds of doing so are so poor you shouldn’t even try. Thus, the surest way to win the loser’s game is to not play, be it at the roulette wheel, the craps table or active investing.
Larry Swedroe is director of research for The BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. He has authored or co-authored 14 books, including his most recent, The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next