Index Funds Not Necessarily a Bad Bet When the Market Turns Bearish

Index mutual funds are known for their low costs, good performance, tax efficiency and other favorable features. But are they sensible investments to hold while the stock market is dropping?

Maybe so.

Supporters say worries about index fund performance in bearish climates are overblown. They contend that index portfolios actually fare better against the competition than is commonly believed, and thus make sense as long-term portfolio holdings.

“A down market affects everybody,” said W. Scott Simon, an investment author and principal at Silver Oak Advisory Group in Encino. “Active fund managers are in the same boat.”

Of course, not even the most ardent indexing fan will tell you that the funds stand a chance of making money in a stiff correction or prolonged bear market. Index funds buy and hold the same stocks that are contained in popular market yardsticks such as the blue-chip Standard & Poor’s 500. Thus, they will tumble if the prices of those stocks drop.

Index funds don’t have the luxury of shifting into defensive stocks during rough weather--another trait that would seem to make them accidents waiting to happen in a bear market.

Yet Simon, author of the book “Index Mutual Funds” (Namborn Publishing, 1998), believes that a lot of active managers don’t cushion the blows of down markets any better than index funds. Even though some actively managed funds can retreat to the safety of cash, they either fail to do so or mistime their moves.

As evidence, he cites the crash of 1987--the last huge hit on Wall Street. Funds pegged to the S&P; 500 lagged the average stock fund by less than 2 percentage points from September through October 1987; both index and actively managed funds tumbled more than 28% during the slide.

John Woerth, a spokesman for the index-heavy Vanguard fund family in Valley Forge, Pa., notes that most actively managed funds invest in smaller companies than those represented in the S&P; 500, the most popular and visible yardstick for indexing.

“In a market decline, you’ll generally see medium and small stocks slide further,” he said. “A myth of index funds is that they won’t protect you as much as an actively managed fund.”

Another advantage of owning an index fund during a weak market is the assurance of knowing your investment will bounce back when the tide turns. This may make it psychologically easier to hold an index fund, rather than an actively managed product, during a slump.

“‘When the market comes back, index funds will outperform on the upside,” Simon said.

The Mathers Fund is a good example of an actively managed portfolio that won the battle but lost the war. The Bannockburn, Ill., fund sidestepped the 1987 crash and finished the year with a stunning 27% gain.

But manager Henry Van der Eb never really got back into the market after that. The fund consequently dropped to near the bottom of the performance rankings, with an annualized return of just 3.6% for the decade ended June 30.

Supporters say the features that make index funds attractive in rising markets aren’t diminished during slumps. These include:

* Lower management costs. Without the need to research individual companies, index funds can afford to shave their management fees. The cheapest index funds, from families such as Vanguard, USAA and Charles Schwab, charge less than 0.5% in total annual expenses.

* Lower trading costs. Because index managers don’t sell stocks often, their funds incur lower trading costs than actively managed portfolios. Trading costs, which include brokerage commissions and dealer markups, are not included in standardized fund expense ratios but do influence performance. Low-turnover index funds also realize little in the way of taxable capital gains that must be passed on to shareholders.

* Broad diversification. Index funds either buy all of the stocks in their target yardstick or a representative sample of companies. By contrast, the holdings of actively managed funds usually are skewed to favor certain industries or themes. When the market turns, broad diversification can be an advantage.

* Consistent portfolios. Investors know at all times what types of stocks an index fund holds. There’s no such assurance with actively managed portfolios. This is a key consideration for people pursuing a careful asset-allocation strategy.

Above all, supporters say, index funds aren’t fighting the eternally tough battle of trying to beat the market.

Simon concedes that certain fund managers will accomplish this at a given time, but he contends that it’s highly improbable that someone will do so consistently--or that investors will be able to predict these future top performers.

“There’s very little evidence, until after the fact, that you can identify who’s going to beat the market,” he said.

Sheldon Jacobs, editor of the No-Load Fund Analyst, gave a plug to indexing in the newsletter’s August issue when he declared that there will never be another superstar fund manager like Peter Lynch.

Jacobs said most fund managers today are more “hemmed in” by strict investment guidelines than the free-ranging Lynch (of Fidelity Magellan fame) ever was. Also, the investment field is much more crowded today than it was two decades ago, making it harder for prospective superstars to gain a significant advantage.

“Being brighter and working harder doesn’t give the same edge to today’s managers that it did to Peter Lynch [in the 1970s and ‘80s], because virtually all professionals now have access to the same information,” Jacobs said.

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Russ Wiles, a financial writer for the Arizona Republic, specializes in mutual funds.

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Are Index Funds a ‘Prudent’ Buy?

Index mutual funds are perceived to be low-cost, tax-efficient portfolios capable of delivering good performance. But here’s an argument you might not have heard regarding them: They’re prudent.

W. Scott Simon, a former attorney-turned-financial advisor, says index funds fit the ideal of prudent investments as defined by the Uniform Prudent Investor Act, which has been enacted by 23 states in recent years, including California. The act provides a legal guideline for trustees managing money for trusts, but the lessons extend to other investors too, he says.

The act requires trustees to “‘exercise reasonable care, skill and caution” when making investment decisions. Trustees should consider index funds because it’s unlikely that they can select individual stocks or actively managed mutual funds able to beat the market over time, Simon wrote in the Estate Planning and California Probate Reporter, a legal newsletter in Berkeley.

Other factors that make index funds prudent include low costs, tax efficiency and predictable portfolio holdings.

“‘Trustees [should] start from the presumption that index mutual funds are the best way to invest,” Simon wrote in the newsletter.