I was given the opportunity at the recent Humans Under Management conference in London to tackle one of the more insidious and resilient myths about index investing — namely that passive investors are particularly prone to bad behaviour.
I’ve included my presentation at the end of this article. You should find it reasonably self-explanatory, but here’s a brief summary is what I said.
The theory that those who invest in index funds and passively managed ETFs are especially vulnerable in the event of a downturn is closely connected to another myth — the idea that actively managed funds provide (to use the phrase favoured by fund house marketers) an element of “downside protection” in falling markets.
Downside protection is a myth
Numerous studies have been conducted which show that active funds are no more likely to beat their benchmark in bear markets than they are in bull markets. In my presentation, I highlighted research by Lipper, Goldman Sachs, Vanguard and S&P Dow Jones Indices — all of which concludes that that active funds perform no better in down markets than index funds, and in many cases considerably worse.
How have active investors behaved in the past?
Active management is often sold to investors and advisers as if it somehow makes it easier to stay the course. It’s instinctively reassuring to many investors to know that, to quote a recent investment manager in the Financial Times, that “there’s someone driving the bus”. But it’s a false comfort.
As Joe Wiggins, himself an active manager, recently explained on his blog, the behavioural challenge facing active investors is particularly daunting. “The more genuinely active a strategy is,” says Wiggins, “the greater the likelihood that it will experience spells of pronounced and often prolonged underperformance, which will be unpalatable for many investors.”
Fidelity Investments conducted a study on its Magellan fund from 1977 to 1990, when Peter Lynch was in charge. His average annual return during that period was 29%, which makes him one of the most successful active managers of the modern era. You would have thought that investors in the fund enjoyed substantial returns, and yet, shockingly, Fidelity found that the average Magellan investor lost money during Lynch’s remarkable winning run. In other words, whenever the fund suffered a setback, money would flow out, and when it got back on track, money would flow back in, by which time investors would have missed the recovery.
How have passive investors behaved in the past?
What about passive investors, then? How do they behave when markets fall? The historical evidence is actually pretty encouraging. Bloomberg’s Eric Balchunas, for example, has shown how, in 2008, the year of the credit crunch, actively managed funds in the US saw outflows of $259 billion, while index funds and ETFs saw inflows of $205 billion. In other words, active investors were net sellers, while passive investors were net buyers.
It was similar story in the downturn between May and October 2011, when the S&P 500 Index fell 20%, and again between May 2015 and February 2016, when it fell 14%. Active investors fled; passive investors continued to buy.
Of course, passive investors are only human, and there are many who do misbehave. There are also large numbers of investors who invest actively using passively managed products. But, generally speaking, investors in index funds and ETFs have historically shown themselves to be relatively disciplined.
There is no room for complacency. It’s up to financial advisers and other financial educators to keep encouraging good behaviour. But the idea that passive investors will, en masse, head for the hills in a blind panic when the next crash comes is completely fanciful.