Three myths of index funds

Learn how actively managed mutual funds can help investors during volatile or down markets.

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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. According to John Sweeney, executive vice president of retirement and investing strategies at Fidelity, “While index fund returns may tend to be closer to the index, 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. If you are a long-term investor, down markets may be the worst time to sell an active stock fund.” (For details, see the myths below.)

Of course, averages don’t tell the whole story. Index funds will tend 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 the myths, the realities, and what you can do about them.

Myth 1: Index funds can spare you from market ups and downs.

Reality: 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.

Myth 2: Index funds can provide better protection from market downturns than active funds.

Reality: 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 major 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 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 Myth 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. (Read Viewpoints: Some active funds rise about a tough year.)

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.

Myth 3: Selling funds during volatile times can reduce losses.

Reality: 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 for you—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. (Read Viewpoints: Some active funds rise above a tough year.)
  • 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.

Bottom line

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 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.

Learn more

  • Research Fidelity and non-Fidelity active and index funds as well as ETFs.
  • Consider professionally managed accounts.
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1. Fidelity Active/Passive Quantitative Study, 2016, which surveyed 3,483 Fidelity customers who are mutual fund buyers.
2. Data based on Fidelity Personal Investing customers, excluding managed accounts, during 2015. The average number of households trading active equity funds each was 250,000.Weeks with a VIX Index of 20+ were considered “volatile” for the purpose of this analysis. The VIX Index is a commonly accepted measure of market volatility. Data from Fidelity Personal Investing, as of March 2016.
3. Fidelity Active/Passive Quantitative Study, 2016, which surveyed 3,483 Fidelity customers who are mutual fund buyers.
4. Fidelity Active/Passive Quantitative Study, 2016. Sample: Fidelity Customers with mutual funds [3,483]. Question: “Please tell us how much you agree or disagree with the following statement: I believe that it's better to stay invested through market ups and downs than to try to time the market.” Rated on a 10-point scale: 1=Strongly disagree, 10=Strongly Agree. Agreement percentage measures those who selected 8, 9, or 10.
Methodology: About the numbers in this story
Myth 1 and Myth 2: Our analysis for Myth 1 and Myth 2 focused on all U.S. large-cap mutual funds tracked by Morningstar between January 1, 1992, and December 31, 2015, including all blend, value, and growth funds within each category and including actively managed and passive index funds. We included funds that did not exist for the entire period (closed or merged funds), to reduce survivorship bias. We eliminated funds identified as passive that were labeled as “enhanced index,” and eliminated funds with tracking errors greater than 1% (which are unlikely to be actual passive index strategies despite their identification in the database). See below for benchmark indexes included and definitions.
Our analysis began with the entire set of funds with available data from Morningstar at any point over the full period: 2,013 actively managed mutual funds, and 115 passive index mutual funds. We selected the oldest share class for each fund as representative; where more than one share class was the oldest available, we chose the class labeled as “retail.”
For the chart in Myth 1, analysis used only active and index funds listing the S&P 500 as the primary prospective benchmark, for clear comparability.
For the chart in Myth 2, actively managed funds were compared to their prospectus benchmark. The results were then converted to an equal-weighted average for each category of funds as shown in the table below. Those results were averaged together, weighted based on the number of active funds in each category, to create results for active and passive products overall. The following table has additional details. Different numbers of value/growth/blend funds may have existed during the different periods under analysis.
Average Large-Cap Active Fund and Benchmark Cumulative Performance
Correction period
Large-Cap Active Fund Category
Average Large- Cap Active Fund Cumulative Performance
Average Benchmark Cumulative Performance Average Large-Cap Active Fund Outperformance
8/31/2000 to 9/30/2001
All Combined -28.02% -32.16% 4.14%
Value -6.80% -15.43% 8.63%
Growth -42.07% -42.18% 0.11%
Blend -24.90% -29.99% 5.09%
3/31/2002 to 9/30/2002
All Combined -27.01% -28.43% 1.42%
Value -26.10% -26.49% 0.38%
Growth -28.40% -29.76% 1.36%
Blend -26.29% -28.23% 1.94%
10/31/2007 to 2/28/2009
All Combined -50.57% -51.04% 0.47%
Value -51.95% -53.35% 1.40%
Growth -49.46% -49.27% -0.19%
Blend -50.33% -51.16% 0.83%
Averaging excess returns: We used Morningstar data on returns from January 1, 1992, through December 31, 2015. We calculated each fund’s excess returns on a one-year rolling basis, relative to each fund’s primary prospectus benchmark and net of reported expense ratio, for each month. We used an equal-weighted average to calculate overall industry one-year returns for each month. (We chose equal weighting for the averages in order to represent the average performance of the range of individual funds available to investors, rather than asset weighting, which may introduce bias into an analysis.) If a fund closed or was merged during a one-year rolling period, its returns were recorded for the months that it was in existence, and the weighting of the remaining funds in the subset was increased proportionally for the remainder of the year.
Indexes: Funds in the analysis for Myth 1 and Myth 2 included active and passive funds tracked by Morningstar and benchmarked to the following indexes: Russell 1000; Russell 1000 Growth; Russell 1000 Value; Russell 3000; Russell 3000 Growth; Russell 3000 Value; S&P 500.
Myth 3: Analysis used Fidelity data on 3.3 million households that had assets in active equity mutual funds as of March 2008. Households that took out at least 20% net of their beginning active equity assets in at least oneof the six downturn periods are classified as downturn sellers; all other households are classified as downturn non-sellers. Buying or selling within managed accounts was not considered. Downturn time periods: May’08-Mar’09, Apr’10-Jun’10, May’11-Oct’11, Apr’12-Jun’12, May’15-Aug’15, Nov’15-Feb’16. The average investor’s cumulative rate of return for each group was calculated using dollar-weighted averaging, to capture the effects of investor flows, then annualized.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

Past performance is no guarantee of future results.

Diversification and asset allocation do not ensure a profit or guarantee against loss.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal. Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments. Investments in smaller companies may involve greater risks than those in larger, more well-known companies.
Active and passively managed funds are subject to fees and expenses that do not apply to indexes. Indexes are unmanaged. It is not possible to invest directly in an index.
Excess return: the amount by which a portfolio’s performance exceeds its benchmark, net (in the case of the analysis in this article) or gross of operating expenses, in percentage points.
Indexes are unmanaged. It is not possible to invest directly in an index.
Russell 1000 Index is a market capitalization-weighted index designed to measure the performance of the large-cap segment of the U.S. equity market.
Russell 1000 Growth Index is a market capitalization-weighted index designed to measure the performance of the large-cap growth segment of the U.S. equity market. It includes those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth rates
Russell 1000 Value Index is a market capitalization-weighted index designed to measure the performance of the large-cap value segment of the U.S. equity market. It includes those Russell 1000 Index companies with lower price-to-book ratios and lower expected growth rates.
Russell 3000 Index is a market capitalization-weighted index designed to measure the performance of the 3,000 largest companies in the U.S. equity market.
Russell 3000 Growth Index is a market capitalization-weighted index designed to measure the performance of the broad growth segment of the U.S. equity market. It includes those Russell 3000 Index companies with higher price-to-book ratios and higher forecasted growth rates.
Russell 3000 Value Index is a market capitalization-weighted index designed to measure the performance of the broad value segment of the U.S. equity market. It includes those Russell 3000 Index companies with lower price-to-book ratios and lower forecasted growth rates.
S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
Before investing in any mutual fund, consider the investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
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