Being passive pays in turbulent markets

Having passively managed funds may be the best pay to ensure your investments survive a turbulent market. This articles looks at the benefits of passivity in the market place.

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    American flags fly at the New York Stock Exchange on Wall Street (July 6, 2015). Structural imbalances in the economy may be to blame for ongoing volatility in financial markets.
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Comparing the goals of actively managed funds and passively managed funds (“index funds”) is relatively simple: Actively managed funds try to beat a given benchmark, while index funds attempt to track the benchmark. So which is better for your portfolio?

Index funds outshine the rest

Numerous studies, including a 2014 Vanguard study, demonstrate that low-cost index funds have displayed a greater probability of outperforming higher-cost actively managed funds. However, many ask whether active funds beat passive index funds on average during turbulent markets. Vanguard’s study also addressed this question.

The theory goes that during a bear market, active managers could move money to cash or defensive securities and avoid the worst of the losses. However, according to the study, managers likely couldn’t move the money at just the right time to make the strategy work. The manager has to time the market right and do so at a cost low enough that the overall benefit is positive.

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The study found that in four of the seven bear markets since 1973, and six of the eight bull markets, the average mutual fund did not outperform its benchmark index.

This has been a relatively turbulent year for the markets, so let’s look at how funds performed. SigFig, an online portfolio tracking firm, did an analysis for CNBC that shows that for the year ending Oct. 31, passive index funds dropped an average of 0.6%, while actively managed funds decreased 1.3% on average.

These performance trends are starting to affect where investors put their money. A recentMorningstar report showed that investors’ preferences are moving aggressively from actively managed funds to passively managed index funds. Estimated net inflows to index funds in 2014 totaled $392 billion, nearly six times the inflow into active funds.

What about low-cost vs. high-cost funds?

The same report also revealed that although most funds have not cut their expense ratios significantly, investors are picking lower-cost funds, which is driving down the overall industry expense ratio. Between 2009 and 2014, only about 24% of mutual funds reduced their expense ratios by more than 10%. However, because investors are moving toward lower-cost funds, asset-weighted expense ratios for all funds fell to 0.64% in 2014 from 0.76% in 2009, a decline of 16%.

The overall movement toward lower expense ratios is good news for investors; research has shown that low expense ratios are the best predictor of the probability of a fund’s success. According to a 2010 Morningstar study, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”

The takeaway: For the average investor in a bear market, it can pay to keep things simple.

This article first appeared at NerdWallet.

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