Indexes Have the Advantage in Bear and Bull Markets

There was yet another Rob Carrick disaster in the Globe & Mail this week, a newspaper that I am losing respect for all the time. After reading the headline,
ETF advantage fades in down market, I knew it was going to be a beauty. He starts off by explaining that index funds and ETFs “clean up” in a bull market.

One of the top no-brainer investing moves is to put money in an exchange-traded fund or index fund if you want to clean up in a bull market.

But why just in a bull market? It is unfortunate that he doesn’t give any reason why indexes might perform better in a bull market (or bear market). The most obvious reason is that index funds or exchange-traded funds represent “the average” but have lower MERs. This same logic should apply to bear markets right? His whole argument that ETFs and index funds “beat” actively managed mutual funds in bull markets but perform poorly in bear market is weak. It rests completely on being selective about what past periods to look at and a belief that mutual fund managers are “market pros [that] are using their training and experience to pick the best stocks.” Couple that with reporters’ tendencies to write about both sides of the story, in this case searching for advantages and disadvantages to both index ETFs and mutual funds even if it means leaving readers with an unfair and inaccurate picture.

In the second paragraph, he mentions that ETFs did not perform that well between Sep. 1, 2000 and Oct. 31, 2007 but from 2002 onward they performed much better than actively managed mutual funds. He thinks he has it all figured out; index ETFs perform poorly in a period that includes a bear market.

. . . the advantage of ETFs isn’t so clear over a longer period that includes a down market. The past seven years are a good example. If you bought ETFs at the peak of the last bull market on Sept. 1, 2000, and held until this past Oct. 31, your returns would look puny compared with many popular Canadian equity mutual funds.

He even suggests that investors consider “investing in the Canadian market, but through mutual funds rather than ETFs” because “the S&P/TSX composite is looking shaky right now after a five-year bull run.”

He describes accurately how the S&P TSX Large Cap index did poorly after Sep. 2000 and explains one of the reasons for this: the fact that Nortel made up close to one third of the index whereas mutual funds were limited to about 10% exposure for each stock. So when Nortel lost almost all of its value after 2000, the index, with more Nortel exposure, would have faired much worse than actively managed mutual funds (in fact, the index performed so badly that the “capped” S&P/TSX 60 index was created after the Nortel debacle). The index would have also faired much better than the actively managed funds between 1997 and 2000 because of Nortel’s gains thus compensating for the loss from 2000-2002; however, he conveniently leaves out the 10-year figures (1997-2997) and only uses a “seven-year comparison prepared especially for this Portfolio Strategy column.” His reason for not using 10-year data is that “a 10-year slice is of little use because many funds and ETFs haven’t been around that long.” I find that rather odd because the TSE/S&P TSX Composite has been around since 1977 and the TD Canadian Index mutual fund have been around for 10 years! Of course I agree that “many funds and ETFs haven’t been around that long,” but since we’re only looking at Canadian equities here, isn’t one Canadian index enough? After all, he only looked at one index for the 7-year period.

I decided to get my own figures from Morningstar’s Fund Selector:

My Method: Using Morningstar’s Fund Selector I searched for funds in the “Canadian Equity” category that have a 10-year return greater than -50%. This allowed to me to find out how many funds have been around for the past 10 years. Then I searched for funds that had performed better than the TD Canadian Index fund over that same 10 year period to determine how many funds beat this index fund. I then repeated the same procedure for 5 yr. and 3 yr. periods. The TD Canadian Index fund’s performance over the 3, 5, and 10 years periods was 19.8%, 20%, and 9.2% annualized, respectively.

As you can see from the table, the indexes beat a large percentage of actively managed mutual funds over the past 3, 5, and 10 year periods. Note also that there is some survivorship bias in these figures. Presumably, in 1997 there were more than 68 mutual funds in the “Canadian Equity” category but only 68 “survived” until 2007. One can assume that the ones that did not survive were more likely to have performed worse than the index, hence their reason for being discontinued, retired, or merged with other funds. So the percentage of funds that performed worse than the TD Canadian Index Fund is likely to be higher than 66% if we could somehow include funds that existed in 1997 but no longer exist in 2007.

Indexes can do even better than this if only the MER was lower. The TD Canadian Index fund has an MER of 0.85% but the iShares CDN S&P/TSX Cap Composite Index (XIC) has an MER of 0.25%. XIC does go back 5 years; however, it wasn’t always tracking the TSX Composite; it used to track the TSX/S&P LargeCap 60 index so I will not look at its performance values. Let’s assume that if XIC (in it’s present form) had existed 10 years ago, it would have performed 0.6% better than the TD Canadian Index Fund over that same period due to its lower MER, or 20.4%, 20.6%, and 9.8% annualized over the past 3, 5, and 10 year periods, respectively. This approximation is consistent with the fact that in 2006 the TD index returned 16.4% but XIC returned 17.0%, a difference of exactly 0.6%. I re-ran my fund searches on Morningstar and here is what the performance would be if XIC existed 10 years ago in its present form with an MER of 0.25%:

As we see once again, the S&P/TSX Composite Index with a 0.25% MER has outperformed over 71% of all actively managed mutual funds in the “Canadian Equity” category in the last 10 year, 5 year, and 3 year periods ending in Oct. 31, 2007. I have not cherry-picked any period and I have shown three different periods, not just one. I have not thrown out any periods based on whether or not they include or don’t include either bull markets or bear markets. The original article only looks at one bear market and concludes that indexes perform worse than active management in bear markets. I am not at all convinced that this is a consistent truth or “rule.” There is lots of data from the US for example that shows that over long periods of time (which include more than just one bear market) indexes handily beat actively managed mutual funds. In A Random Walk Down Wall Street, Burton Malkiel quotes a Lipper study (2007 edition, pages 267-268) that found that from Dec. 31, 1985 to Dec. 31, 2005, the S&P 500 index beat 82% of mutual funds and on average performed 1.5% better than the average fund per year. I would find it very hard to believe that one could increase performance even more by switching from indexes to mutual funds at certain times, or even holding some balance of mutual funds and indexes. Even if we looked at more than one bear market and it turned out that indexes did perform worse in every bear market, without being able to predict when future bear markets start and end, would this information be helpful? How would you know when to switch to mutual funds and then back into index ETFs for the next bull market? You would be guessing and in the end you would lose out due to commissions spent on buying and selling the ETFs and the higher MERs on mutual funds.