Vanguard Indexing Guru Examines Fund Performance in Bear Market By John Spence July 24, 2002

The financial media seems to love to take shots at indexing in bear markets, and now is obviously one of those times. The Wilshire 5000 index, the yardstick for the broad domestic stock market, is down a wrenching 16.60% for the year ending June 2002, according to Morningstar.

Many financial columnists have boldly declared that we are in a stock picker's market, and that investors who opt for index funds are doomed to underperform. The argument is that active managers can sidestep troubled stocks, while index funds must remain fully invested in a benchmark. Given the crisis of confidence in corporate America and the Enron and Worldcom record-breaking bankruptcies, this notion has some appeal, at least on the surface.

However, Vanguard index fund manager Gus Sauter has looked at fund performance data against relevant Standard & Poor's benchmarks, and the evidence indicates otherwise. The first comparison shown below is a short-term examination of how funds have performed against the appropriate index since the beginning of 2002 through May (five months).

-Reprinted from In The Vanguard, Summer 2002

Although this is a relatively short time frame, the numbers shown above appear to refute the argument that active managers can add value in a falling market.

Next, Sauter did the same comparison but stretched the time frame out to five years ending May 2002. Given the strength of index funds over long time periods, the results below should come as no surprise.

-Reprinted from In The Vanguard, Summer 2002

The numbers clearly show that active funds have a tough time besting their relevant benchmark over short- and long-term periods. However, Sauter says indexers shouldn't get too caught up in the active versus passive debate.

"While these comparative results are useful in putting performance into perspective, they also unfortunately foster a horse-race mentality of investing, focusing on which steed - active or passive - will win the race," wrote Sauter in his commentary. "The point of an index fund is not to beat anything. The point is to give you diversified exposure to the entire market (or a specific part of the market) and to capture an extremely high percentage of the returns of that market in a very tax-efficient fashion."

Sauter's analysis underscores a subtle point. Indexing may seem like a surefire path to mediocrity, but an amazing number of active funds struggle to beat "mediocre" returns. There are two main reasons for this: active funds are handicapped with higher fees and taxes due to increased turnover. Anyone who makes the claim that indexing is an outdated fad should at least take a gander at the performance numbers.

Finally, financial columnists who list top-performing funds as evidence that indexing doesn't work are doing investors a disservice. Some active funds will always beat the indexes, but finding them in advance is another matter entirely.

References

• "Proper Perspective On The Passive Approach." George U. Sauter. In The Vanguard, Summer 2002.