Over the last decade or so, index funds (also called passive funds) have grown in popularity vs actively managed funds. Index funds are a type of mutual fund that is composed of stocks that mirror a financial market like the S&P 500. Their popularity is well deserved because these funds charge very low fees and have outperformed most actively managed funds since 2009. Actively managed funds are portfolios constructed and directly managed by a fund manager or private wealth management advisor, such as WealthArch Investment Services.
Despite that, there is a sea change that is occurring. Inflation and interest rates are finally on the rise after being abnormally low since late 2008. While fiscal stimulus has continued until today, past monetary stimulus is being reversed slowly towards historical norms.
This new landscape likely increases the possibility that active managers will do better over the next decade compared to the last decade.
Exhibit 1
Index Funds Have a Momentum Strategy
The most popular index funds are market-weighted. That means index funds own more stocks that have gone up in value.
To simplify this concept, let’s pretend we were creating an index fund investment strategy using a 2-stock index fund starting with an equal amount of $100.
If stock A doubles and stock B remains the same, you’ll have $200 in stock A and $100 in stock B.
Exhibit 2
| AT INCEPTION | AT INCEPTION | AFTER STOCK A DOUBLES | AFTER STOCK A DOUBLES | |
| Stock A | $100 | 50% | $200 | 67% |
| Stock B | $100 | 50% | $100 | 33% |
| TOTAL | $200 | 100% | $300 | 100% |
In this example, investors in this 2-stock index fund would, therefore, own a higher % of stock A than stock B compared to when the index was created.
As a result, if your index fund investment strategy means blindly adding money regularly to index funds when stocks are trending upward, then you are buying more and more of the stocks that have gone up.
This momentum strategy is excellent when stocks are steadily going up, just like they did from 2009-2021, but what happens if stocks enter a bear market?
No one knows for sure, but if the momentum shifts, we could see index funds underperforming many active managers, as shown in Exhibit 1.
Index Funds Don’t Have Downside Protection
I’ve met people who told me that their primary reason for investing in an index fund (vs an actively managed fund) is because they think it is “safe.”
They forget or are unaware that the S&P 500 index was down around 40% in 2008 and down around 20% in 2022.
Index funds have low fees, but they are not “safe.” Investors in index funds are not protected from market risk, primarily because they are always fully invested.
On the other hand, a few active managers, like WealthArch, aren’t afraid to keep cash on standby when the markets are expensive.
Index Funds are Robotic
As mentioned earlier, the most popular index funds are market-weighted. The S&P 500 comprises the largest 500 companies by market cap in the US.
This means that S&P 500 investors own all these 500 companies regardless if they are overvalued, facing secular headwinds, are poorly managed, etc.
In other words, because an index fund follows a formula with minimal intervention, the fund will own some good and some bad investments. This is one of the main differences between index funds vs actively managed funds.
Some active managers, like WealthArch, are able to position their client portfolios overweighted towards defensive and undervalued investments, so even when a large correction happens, their stocks overall lose less than the index funds.
The Average Person Buys In and Sells Out of Funds at the Wrong Time
Most investors chase the stock market when it’s hot and panic when it declines. Because most people incorrectly time the market, they earn a significantly lower return than both index funds and actively managed mutual funds.
Exhibit 3
Conclusion
At WealthArch, we have the opposite of a momentum strategy. We always aim to be greedy when the markets are fearful, and fearful when the markets are greedy. In other words, buy low and sell high.
We conduct in-depth investment research to invest in companies that have attractive risk/reward propositions and avoid poor ones.
Because of our value investing philosophy, we require a margin of safety or buffer that helps reduce the risk of permanent loss.
Finally, we help our clients avoid panicking when the markets go down. In fact, we educate and encourage them to be aggressive, because this is when the best risk-adjusted investments are made. Making sure that you’re informed about index funds vs actively managed funds is important to us.
Please let me know if you have any questions or comments.
