Even fans of index funds often believe they do worse than funds with active managers during bear markets. The idea is that a savvy manager can shift money out of a crashing asset class in time to improve overall performance. As it turns out, "most events that result in major changes in market direction are unanticipated," says Christopher B. Philips, CFA, a senior analyst in Vanguard's Investment Strategy Group.
The facts, according to Vanguard: In four out of seven bear markets since January 1973, the Dow Jones U.S. Total Stock Market Index beat the average actively managed fund. The two bears in which many funds did better than the index were both in the 1980s.
Looking at a separate study by Lipper, active managers underperformed the S&P 500 in the six market corrections between Aug. 31, 1978, and Oct. 11, 1990. The average loss for the S&P during those bears was 15.1%, compared with 17% for large-cap growth funds.
Another myth is that index funds will be forced to sell-and realize capital gains-when investors run for the doors. The truth is that net cash flow into stock index funds was positive in the last two bears. According to the Investment Company Institute, from 2000 through 2002, stock index funds received more than $62 billion in new money. In 2008, stock index funds netted $31 billion.
Redemptions also needn't lead to capital gains. As Philips explains, managers can sell stocks bought at high prices during outflows, creating losses that can be stockpiled to offset gains. "Redemptions in a bear market can help an index fund remain tax efficient, creating losses, not gains."
Indexing has other advantages, as well. The funds tend to be more diversified, unless they are designed to track a narrow class, and are therefore less volatile. They are relatively predictable since an active manager can often choose to move between asset classes. Index funds are also cheaper to run.
In addition, a Financial Research Corp. study found that a fund's expense ratio was the most reliable gauge of its future performance, with low-cost funds consistently above average. This cost advantage accumulates over longer time periods, Vanguard reports. Bear markets tend to be short, which might help active managers. In fact, they haven't earned their higher fees in white-knuckle times.
And what about during bull markets? Active managers fared even worse. In seven of the eight bulls since 1971, the Dow performed better than the average actively managed fund.