Indexing Gains Broad Appeal
The 1990s were remarkable years for US index funds. The extraordinary run of the market caused the S&P 500 to climb from 371 in October 1991 to an almost inconceivable 1,553 in November 2000. The cumulative price return for the period was over 318%, representing an average annualized return of 14%. It was a decade when active managers struggled to keep pace with passive benchmarks. Characteristically biased towards value and small cap stocks, active managers consistently fell short of the large cap growth-dominated market.

Index fund managers, academics, and many institutional investors have recognized the merits of passive investing for decades. However, it wasn't until the boom of the 1990s that indexing gained popularity among even the most skeptical groups of investors. It was during this time that retail and non-US investors, historically cool to the idea of "settling" for mere market returns, jumped on the indexing band wagon, which had been long occupied by US institutional investors. Index mutual funds experienced unprecedented in-flows while institutional investors increased their allocations to passive funds, which now represent an average of 40% of all institutional US assets¹.

A New Era Has Arrived
As the 90s fade we face the challenges of a new era. Market volatility has increased. A weak global economy shows little sign of a near-term turnaround. And while the stock market has achieved a moderate recovery from the lows following September 11th, uncertainty surrounding the duration of the current slowdown and the outcome of the war on terrorism has caused some investors to question their appetite for equities in general, and indexing in particular. While during the 90s indexing was seen as the buoy that enabled investors to ride the wave of the technology boom, today many index investors wonder whether indexing is an anchor threatening to carry them to the depths of the next market decline.

Some active managers have seized upon this environment of uncertainty and fear to make the claim that indexing is now more dangerous. They allude to the emergence of a "stock pickers' market" and allege that passive investors are senselessly allowing index funds to "drag them down" with the market—as if somehow the market is a separate and distinct entity from investors themselves. They also assert that active managers can provide "downside protection" for investors in this type of environment. This line of thinking ignores several important reasons why investors make index funds a strategic and significant piece of their investment portfolios. It also promotes a false impression that active managers have, in fact, been successful in providing protection for investors in down markets.

The Logic Behind Indexing Holds in Any Market Environment
Passive investing is a long-term strategy. Those who choose to index do so for strategic reasons which, over time, result in superior performance with little ongoing maintenance and no surprises. Relative to active mandates, management fees are lower. Portfolio turnover and associated transactions costs are lower. And, administratively, index funds can be less expensive and easier to implement due to lower monitoring costs and fewer manager changes. Indexing also offers broad diversification and stability of exposures—comforting attributes during a period of market uncertainty.

Also important, indexing eliminates the uncertainty and risk associated with choosing the wrong active manager. Just as active managers employ hundreds of strategies to identify promising stocks—often without success—investors continuously seek a successful method for choosing managers. The risks associated with bad manager selection increase in volatile markets when return dispersion is great. Passive investing is a time-tested strategy for ensuring that portfolios keep pace with the market and capture the equity premium over time. Indexing empowers investors to rise above the panic brought on by random shocks to the market, and to rest comfortably in the knowledge that they have implemented a strategic plan designed to ride out short-term volatility. During periods of market instability, it is particularly important that investors not confuse indexing with equity risk. It can be tempting to associate indexing with declines in wealth resulting from market downturns. These fluctuations in wealth are the price investors pay—both active and passive—to enjoy the equity risk premium over time.

Can Actively Managed Strategies Protect Investors from Down Markets?
Still, some investors may be compelled to seek out the "protection" of an active strategy during uncertain times. The urge to do so reflects the fact that investing in index funds is simply easier to stomach when the direction of the market is positive. But investors should feel confident in their index allocation in both up and down markets, not only for the reasons stated above, but because active strategies offer no better protection in down markets than index funds.

Many active managers claim that they can position portfolios more defensively during market downturns. This may involve a change in the portfolio composition or simply an increase in cash reserves. If we believe that active managers can provide protection in these ways, the following assumptions should hold:

• Active managers can and do successfully predict bear and bull markets.
• Active managers increase cash reserves or re-align portfolio holdings accordingly.
• Active managers make better stock-picking or cash-allocation decisions in down markets than in up markets.
• Protection in down markets compensates for underperformance in up markets.

Chart 1: Active Manager Cash Reserves vs. S&P 500

Chart 1 suggests that these assumptions do not hold. Market timing has proven one of the most daunting challenges for investors, which is why strategic allocation decisions are so important. Even the notion that active managers adjust cash reserves in anticipation of changes in market direction is false. First, institutional money managers are generally expected to be fully invested at all times and therefore don't have much discretion to adjust cash positions. Over the past decade, cash holdings have declined steadily while the market has continued its upward march. This means that just as the powerful bull market of the 90s was running out of steam, active manager cash positions were at an all time low—the exact opposite of what one might expect from a defensively positioned portfolio.

Chart 2 illustrates that active managers were equally unsuccessful at market timing in other decades. It highlights how cash positions often peak at the precise moment that a market upturn begins. Conversely, the percentage of cash held in portfolios is lowest right before a market downturn. If one believes that active managers struggle to beat rising markets, why then do investors believe those same managers can find more success in falling markets? The empirical evidence offers no proof that such skill exists. Regardless of the manager universe, the definition of "down market", or the timeframe used, the results are the same. There is nothing to suggest that investors would be better off in active strategies during declining markets.

Chart 2: Active Manager Cash Positions at Marketing Turning Points

• Callan Associates defined rising and declining market cycles from 1974-1997. Out of six declining markets, the median manager outperformed three times and underperformed three times.

• A Charles Schwab study concluded that in 20 market declines since 1986, index investors ouperformed active managers 11 times.

• Morningstar's analysis of seven asset categories showed that during the current market downturn, active managers have outperformed indexing in three out of seven categories.

Regardless of whether active managers underperform or outperform in bear markets, they often stay in cash too long and miss critical turning points in the market. Chart 3 shows that in two out of three twelve-month periods following our most severe bear markets, active managers failed to keep pace with the rising market.

Keeping Pace with Rising Markets is Critical
Even if active managers are able to provide added value in declining markets, their long-term returns may still fall short of the market overall. This is due to active managers' general inability to keep pace with rising markets which have been longer in duration and greater in magnitude than falling markets. Therefore, it is essential that managers keep pace in both market environments. Since 1974, managers would have had to outperform in down markets by an average annualized return of 3.2% in order to compensate for underperformance during market expansions.

Conclusion
The current market environment presents a perfect opportunity for index fund investors to reaffirm their long-term strategic choices. Indexing is a successful, reliable, and robust approach for any market environment because it fulfills important long-term investment objectives. During volatile markets, index investors can be at ease knowing that their passive portfolios continue to deliver low cost and flexible implementation, broad diversification, consistency, and transparency. Even in these comparatively challenging markets, there is little question that index funds will perform reliably and enable investors to achieve their long-term goals.

November 30, 2001