Are Index Investors More Vulnerable to a Market Downturn?

A recent blurb on a financial media website got my attention, but not for the reason it probably intended. The headline, Bear Market Signal: Robos Get Quiet as Top-Heavy Index Funds Hit the Limit, seems to indicate index funds are at a tipping point. 

The writer contends that the S&P 500 Index’s performance over the last few years has been generated largely by a handful of stocks (the FANG stocks). As he correctly points out, 350 of the 500 companies are down more than 10%. He goes on to say such a circumstance is a classic opportunity for “nimble investors to rotate.” 

In theory this all seems very plausible. Through hard work and intelligence, stock experts should be able to identify the stocks that will do well prospectively and avoid the clunkers. In reality, the data proves that this is exceedingly difficult and unlikely to produce superior results.

For starters, let’s look at the last few years when Facebook, Amazon, Netflix and Google led the market. Presumably the same smart people who might identify the new market leaders would have forecast that these few stocks would experience mouth-watering returns, and avoided the 350 or so “zombie stocks.”

However, according to SPIVA (a service that tracks mutual fund performance) for the 3-year period ending June 30, 2018, only 22% of large cap funds managed to beat the S&P 500. Those aren’t the odds that lead to a successful investment experience. Given the facts, what might lead a reasonable person to conclude a different outcome could be achieved moving forward?

What about a recession or down market? Surely the “wise guys” of Wall Street have better records during times of market turmoil. Unfortunately, the data (this time from State Street) indicates otherwise. In 2008, when the S&P 500 fell 37%, less than 30% of stock pickers beat the market. 

As Edwards Deming famously opined, “without data, you’re just another person with an opinion.” In our view, being a successful investor requires abandoning hope in favor of experience. 

#TEBI #Investing