Index Funds Will Be Fine Confronting Cruel Markets
(Bloomberg Opinion) -- Every now and again, I come across a point of view that is so wrongheaded and misinformed that I am compelled to push back against it. The claim that passively managed index funds will blow up in the next stock market correction is exactly such a viewpoint -- nevermind that many of these claims and concerns have already been debunked.
Just by way of background: The author who made this assertion is British, and low-cost, passive index funds have a much shorter history and track record there than in the U.S. Large U.S. providers of index funds such as Vanguard Group, BlackRock Inc. and State Street Corp. and others have a well-established history and the impact on markets and investor behavior is reasonably well-documented. I suppose it is natural to fear what we do not fully understand. Perhaps the antipathy to index funds will evolve based on time and experience.
Still, purveying misconceptions and misunderstandings deserves to be countered, wherever and whenever they occur. That is our charge today.
In a widely circulated piece, the Times of London columnist and Sky business presenter Ian King cited Baltimore Technologies as an example from the dot-com collapse as evidence of “a salutary lesson to those who preach the virtues of index trackers in offering low-cost, low-risk exposure to the stock market.” The company was an internet security business based in Dublin that was included for a short time in the benchmark FTSE 100 Index. It was one of the companies, along with others, that imploded in the tech meltdown of 2000.
It’s a bizarre anecdote, more along the lines of a non sequitur. Lots of tech companies and the funds that held them blew up during that period. But here's what's oddest about this line of argument: Investors in active funds suffered as much or more than their passive compatriots. Just consider for a minute an actively managed tech funds like the Jacobs Internet Fund, which fell 79 percent in 2000 and 56 percent in 2001, according to the Wall Street Journal. That's much more than the overall decline for the stock market. If you were unfortunate enough to have subscribed to George Gilder’s Telecosm, a technology newsletter that many in the active stock community read, you fared even worse. In 2002, Wired reported that most of the companies Gilder touted had lost 90 percent or more of their value during the prior two years -- that is, if they were still even in business.
As best as I can tell, the indexers rode out the dot-com collapse and participated in the subsequent recovery as well as or better than actively managed funds. In an email exchange, David Nadig, managing director at ETF.com, made this observation:
In a crash, the index fund manager has a really hard job – he has to do exactly *nothing*. They don't sell. They don't buy. Mostly, they wait, because they know that *after* the crash, they're going to get a lot of new money coming in.
What King may have inadvertently demonstrated is the virtue of low-cost indexing: Although many fund managers both active and passive were mangled by the dot-com collapse, those funds that made concentrated bets did even worse. The momentum investors and it's-different-this-time optimists were utterly blindsided by the post-Y2K revenue and earnings shortfalls in March 2000. If you were invested in concentrated tech or telecom, you were subject to a plunge of about 80 percent for the sector during the next 30 months.
Perhaps this entire exercise is asking the wrong question. Index funds trade relative to their underlying holdings -- in other words, the indexes themselves. Trying to somehow differentiate these funds is simply the wrong sort of query. The better question is “How will the indexers themselves behave during the next crash?”
We already have the answer to that question, courtesy of how investors themselves behaved during the financial crisis. My Bloomberg colleague Eric Balchunas points out that during the 2008 credit crunch, the money flows were into index funds and exchange-traded funds; more than $205 billion was put into these funds while active funds experienced $259 billion in outflows. In other words, the 57 percent sell-off of U.S. equity markets during the financial crisis gives us a good idea how passive indexers will behave when markets crash: they become net buyers while active funds become net sellers.
Beyond the 2008 crash, we have seen several market corrections since 2009. As my colleague, Michael Batnick observed, from May to October 2011, the Standard & Poor's 500 Index fell about 20 percent. Again, between May 2015 and mid-February 2016 the S&P 500 fell about 14 percent. Other indexes, such as the Russell 2000 fell even more. And what happened? Passive index funds continued to gain market share at the expense of actively managed funds.
One last observation: King notes that in 2016 and 2017, active management firms closed more funds than they opened. “Those are only the fourth and fifth years in which that has happened in recent decades," he wrote. "On the previous three occasions, those fund liquidations took place after market reverses.”
Which raises the question: Just who was "cruelly exposed" in those corrections? By all lights, it looks like it was the actively managed funds.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation.”
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