As the saying goes, there is no free lunch with investing. When you invest in stocks, you take on the risks that come with market volatility in the hopes of getting a positive long-term return. One of the scariest things for many investors is the risk that a downturn hits at a particularly bad time—like when they are about to retire.
At times like these, you may discover you can’t handle quite as much stock market risk as you had thought. Maybe you underestimated the impact that a stock market decline would have on your account balances or were overconfident in your emotional tolerance for market ups and downs. Or maybe you were surprised to find out that a stock index fund does not offer much in the way of downside protection when the stock market plummets.
In fact, a recent Fidelity survey found that many investors think index funds, which attempt to match a market benchmark like the S&P 500 (before fees), are less risky than active funds, which attempt to outperform a benchmark.1 That may help explain why during 11 weeks of heightened market volatility in 2015, investors bought index funds but sold active funds at seven times the average rate during nonvolatile weeks.2
Fidelity research suggests that such moves could prove counterproductive. Index fund returns may tend to be closer to the index, but that doesn't always mean they are better. While individual results vary, on average, large-cap active funds have actually outperformed during the last three bear markets. (For details, see below.)
Of course, averages don't tell the whole story. Index funds are designed to track the benchmark index closely, while active funds may vary more, with some outperforming the benchmark and others underperforming. With so much investment commentary focused on the "active vs. index" debate lately, it can be easy to get confused. The Fidelity survey3 found three striking misconceptions about the differences between active and index funds. Here are some facts to consider the next time the markets get rocky.
|1:||Both active and passive funds come with market risk.|
Do you think index funds add more stability to a portfolio than active funds? More than half (51%) the investors in our survey did, while one-fifth believe stock index funds can protect them from market ups and downs. That assumption could be dangerous. Both index and active stock funds carry "market risk" — returns will move with the market in both up and down periods. The average S&P 500 fund has experienced large swings in one-year performance, whether that fund is active or passive (see chart below).
As noted, averages have limits, but the results do show that the short-term risks of large market swings remain for both types of funds.
Tip: If you can't stomach the ups and downs of your portfolio, start by revisiting your investment strategy. Instead of shifting between active and passive products, consider a more conservative asset mix that might include fewer stocks and more bond investments. As always, make sure your asset allocation reflects your risk tolerance, financial situation, and time horizon.
|2:||Actively managed funds may lose less than index funds during bear markets.|
Our research showed that, on average, actively managed large-cap stock funds lost less during recent bear markets than large-cap index funds. Yet eight out of nine investors surveyed by Fidelity didn’t believe it. Index funds, by seeking to match the market before fees, are exposed to similar market risk as the index.
Active stock funds, which seek to outperform the market over time, may be able to take actions that reduce losses during downturns, which can help a good active fund outperform over a full market cycle even if it lags during bull markets.
Take a look at the table illustrating the average performance of large-cap domestic equity funds over the last three major corrections. "Many other studies look at performance by calendar year or use the same-style benchmark for all funds in a particular category. We believe it is also important to compare the performance to the benchmark stated in each fund’s prospectus and to look at longer market cycles, as opposed to calendar periods," says Darby Nielson, managing director of quantitative research at Fidelity.
Therefore, we looked at large-cap fund performance over the peak-to-trough periods of the last three extended bear markets and grouped active and index funds by each fund's stated primary benchmark. (See the methodology section for more details). "We think this gives investors a better indication of how large-cap active funds have actually performed, on average, during bear markets," said Nielson. "Our research dispels the notion that index funds always perform better in market downturns."
The Fidelity analysis finds that, on average, active funds lost less than index funds during the last three market downturns. While averages have limits, as noted above, it is important to note that the performance advantage of the average large-cap active stock fund versus the average large-cap passive fund generally held across the value, blend, and growth categories. The 2007-09 bear market was the only period when large-cap active stock funds did not have a decisive advantage across the value, blend, and growth categories, as active funds in the large growth category narrowly underperformed index funds in the last extended market downturn.
The results were particularly noteworthy in the large blend category—often considered the most efficient and hardest area of the market for active funds to beat index funds. During the last three market downturns, the average active large-cap blend fund outperformed its prospectus benchmark from 0.83% during the 2007-09 downturn to more than 5% during the 2000-01 correction. (For more details on performance by style category, please see the endnote for 2.)
"We think this outperformance is likely due to active managers' ability to select market-beating stocks even when the market is going down, or to reduce losses by holding lower stock exposure before a sell-off," says Nielson.
But, of course, you cannot buy the "average" fund. So how do you pick the right actively managed fund that can potentially outperform over an entire market cycle? Recent Fidelity research found that if you limit your search to low-cost funds from the largest fund shops, the average active fund has outperformed the average passive fund and the market over a market cycle.
Tip: If you're the kind of investor who buys and holds through a full cycle, remember that active funds may lag during bull markets, but make up the difference during market downturns. So, if you are in a fund that has had positive relative performance over a full market cycle, you may want to stay the course—particularly when market volatility hits.
|3:||Commitment to an investment plan has potential benefits.|
Here's a misconception many investors realize is not true, but get trapped by anyway. A full 77% of mutual fund investors in our survey believe that it’s better to stay invested through market ups and downs than to try to time the market.4 But many investors find it difficult to stay the course when the market shakes, rattles, and rolls—and may try to sell out funds to avoid short-term losses. Unfortunately, selling in downturns can lead to significant underperformance, for both active and passive fund investors.
Fidelity looked at more than 3.3 million investors who held active stock mutual funds from April 2008 to March 2016, and divided them into groups of "downturn sellers" and "downturn non-sellers." During the six major downturns from 2008 through 2016, more than 1 million Fidelity brokerage customers sold 20% or more of their actively managed Fidelity stock fund investments, while the rest held steady.
While some people may have been selling because they had changed their strategy, or because they needed to access their money, some may have simply been trying to avoid short-term losses. At first, selling may have felt good. But over time, those good feelings might fade if you missed out on market rebounds.
The analysis shows that investors who buckled their seatbelts and stayed invested beat the downturn sellers by an average 1.5 percentage points annualized. That difference adds up. From 2008 to 2016, a hypothetical $10,000 investment would have grown to $14,300 for those who reduced their active holdings during downturns. But for those who stayed the course, that same $10,000 would have grown to $16,000—11% more (see graph below).
Tip: Instead of trying to sell out of funds during downturns, try to come up with a strategy you can live with in a variety of markets, and stick with it. Remember that actively managed funds may potentially help cushion the risk of loss during downturns. But whether you invest in active or index funds, the key is to set the mix of investments—and stick with it, in good times and bad.
- Consider how long you are going to be invested, your risk tolerance, and financial situation to determine the right mix of stocks, bonds, and cash for your portfolio.
- For your stock portfolio, consider an appropriate allocation to various markets (U.S. and international) and categories (large-/mid-/small-cap, growth/blend/value, or sectors).
- For your bond portfolio, be diversified by maturities, credit quality, and issuers.
- Look for funds with fees that are clear and reasonable relative to peers in the same category.
- Consider active funds from fund families with extensive resources.
- Whatever your target investment mix, stick with it during down markets. That discipline will provide you with the potential to build wealth over the long term.
Index funds and passive ETFs can provide convenient, low-cost diversification, and could be a good fit for many portfolios. But these products don't inherently reduce risk, limit losses in a downturn, or make market timing any more successful. So don't be fooled by common myths. Fidelity believes that active stock funds can also be a good fit for most long-term investors' portfolios, in both up and down markets. In addition, our data shows that the common refrain that active doesn’t stand a chance versus passive index funds and ETFs is not true, and the focus on the active-passive debate often obscures the much more important issues of good savings habits, appropriate asset allocation, and taking a long-term view.
If you are concerned about reducing portfolio swings or potential losses, focus first on your asset allocation. Once you've determined how much exposure to the stock market is right for you, consider whether well-selected actively managed funds can reduce the volatility of your portfolio and the risk of loss. After you've chosen funds you like, stay the course so you can reap potential benefits over a full market cycle.
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