Indexing Has Benefits in Both Bear and Bull Markets

Tracking an index isn't just an investment strategy for bull markets, Vanguard Managing Director Gus Sauter recently told European investment professionals. The advantages of indexing make it a sound choice for any market environment.

Many believe indexing strategies—which seek to earn returns as close to the market as possible and expose investors only to market risk—don't work as well as actively managed approaches during bear markets, Mr. Sauter said. Index funds, in fact, do decline commensurately when the markets decline. However, relative to active management, indexing historically has performed favorably in down markets. Equally important, the strategy has tended to outperform its active counterpart significantly in subsequent market rallies.

A Case for Indexing
Speaking at investment symposia conducted by Vanguard in October, Mr. Sauter described indexing as a viable alternative to active management. "It's a prudent, cost-effective way to gain complete exposure to the market or a market segment, and not just the Standard & Poor's 500," he said. "In fact, an indexed approach is effective for all asset classes."

Mr. Sauter made a strong case for indexing using an argument first proposed by Vanguard board member Dr. Charles D. Ellis in his book, Winning the Loser's Game. Dr. Ellis asserts that investors in aggregate own the entire market; that is, for every investor who outperforms the market, another investor must underperform it. As a result, these investors must collectively earn the market's rate of return before costs.

However, management fees and transaction charges reduce those returns. When costs are taken into account, a majority of investors underperform the market and only a minority outperform it, ultimately making investment performance a "loser's game."

Historical data bears out the argument. Over 15 years, 79% of all U.S. equity mutual funds underperformed the market, while just 21% outperformed it net of fees. Performance data from European and global markets tell a similar story, even before costs are subtracted from the equation. Over 3-, 5-, 10- and 15-year periods, the markets outperformed approximately 80% of European and global diversified equity funds on a gross of fee basis. (See chart.)

Like active funds, index funds incur costs. However, the expenses are by nature lower and thus provide investors in indexed funds with a significant advantage over investors who pay higher costs investing in actively managed funds, especially over the long term. "Indexing hasn't beaten all actively managed funds over time," Mr. Sauter said. "However, it has beaten a majority of funds, largely because of its low-cost approach."

Bulls, Bears, or Both
Low costs are an advantage to index investors no matter the market's direction. However, the strategy of indexing requires full investment in the market at all times—an advantage in a bull market, but a disadvantage in a bear market, Mr. Sauter remarked. Many perceive active managers, with their ability to reduce a portfolio's investment in equities and defensively increase cash holdings, as being able to outperform an index and curb a portfolio's losses when the market falls.

In reality, active managers have not been able to time bear markets consistently. While European general equity managers, for example, outperformed the market in three bear markets since 1987, they have underperformed the market by 6% in the most recent downturn. (See chart.) "Investors who believe active managers are going to avoid a bear market entirely are clearly mistaken," Mr. Sauter said.

In addition, active managers tended to underperform on subsequent upswings. Active managers in Europe substantially trailed the market in the subsequent 12 months following the last three downturns, primarily because they tended to maximize their cash exposure at market low points.

Index funds, on the other hand, capture all of a market's returns during a rally, minus marginal costs, because the funds are always fully invested. And that's precisely why indexing is an appropriate strategy for bear, as well as for bull, markets.

"Obviously, investors would prefer not to be invested at all in a bear market," Mr. Sauter said. "But there is no clear winning strategy when it comes to avoiding a downturn. Relative to active management, the case for indexing holds up very well in any market environment."