Conventional wisdom states that index funds do very well in an up stock market but stumble during a bear market.
The logic goes that an active manager will be able to see the signs of a downturn in the stock market and know when to get defensive. An index fund, on the other hand, will just stay in the stock market and rack up those losses.
I think we can all agree that we are currently in a down market, so let’s examine how the index funds did versus their actively managed peers.
Morningstar rates all mutual funds against funds in a similar part of the market. It gives them a percentile rating against those peers. A rating of 10 means a fund performed in the top 10 percent of all funds, and a rating of 90 means it was in the bottom 10, or that 90 percent of funds outperformed it.
Now, if conventional wisdom was right, we would expect to see the year-to-date performance of broad index funds to be far below average. That would imply numbers much greater than 50. As of April 25, the Morningstar ratings are as follows:
YTD % Ratings
Vanguard Total Stock Market (VTSMX) 39
Vanguard Total International Stock (VGTSX) 26
Vanguard Total Bond(VBMFX) 21
The average of the three index funds beat more than two-thirds of their peers during this short time period. That’s not all that different than during an up market. So what gives?
The logic that index funds don’t work during down markets can be shown to be flawed by using some simple arithmetic. In an up market, if the market returns 10 percent and the average dollar invested cost is 2 percent, then the net return will be only 8 percent. The same holds true in a down market. If the market loses 10 percent and the average dollar invested cost is 2 percent then the average return will be minus 12 percent.
So if the average investor lost 12 percent and the index investor was only paying 0.1 percent, then they will beat the return of the average dollar invested by 1.9 percent (2 percent minus 1.9 percent). The math is that simple and it remains that simple regardless of what direction the market decides to go.
There are some technical reasons why it’s possible for a low-cost broad index fund to be rated below the 50th percentile for short periods of time. They have to do with the definitions of peer groups and the amount of cash that actively managed funds hoard, but I’m going to spare you this technical discussion.
The next time you hear that active investing is better during a flat or down market, remember the rules of simple arithmetic: total market return, minus costs, equals net investor return. When you hear that it’s now a stock pickers market, the person is really saying he doesn’t believe in arithmetic.
Granted, he doesn’t actually know he’s saying this.
Owning the broad stock market index with the lowest costs will beat the average active fund during any period of time. Again, this is true no matter what crazy ride the market takes us on. This is according to Nobel Laureate, William Sharpe, in his paper “Arithmetic of Active Management.”
It’s simple arithmetic that any second grader could comprehend.
In the most recent Berkshire Hathaway annual report, Warren Buffet goes through the same arithmetic and concludes, “… as a class, the helper-aided group must be below average.”
Even more important, however, it’s the long-term that matters. During the last 10 years, these broad index funds have averaged in the top 20 percent as shown here.
Vanguard Total Stock Market (VTSMX) 26
Vanguard Total International Stock (VGTSX) 10
Vanguard Total Bond (VBMFX) 20
By my calculations, you’d have less than a 2 percent chance of finding three funds that averaged this high. And if your luck doesn’t land you in this top 2 percentile, then your nest egg underperformed the boring indexer and your financial goals aren’t as far along as they could have been.
Remember, the next time someone tells you that active investing works better than owing the entire market with the lowest costs, they are really saying they don’t believe in simple arithmetic.
Allan Roth is a CPA and Certified Financial Planner. He is the founder of Wealth Logic LLC, an hourly based financial planning and licensed investment advisory firm, and is an adjunct finance faculty member at the University of Colorado at Colorado Springs. He can be reached at 955-1001 or at ar@DareToBeDull.com.