To Index, Or Not To Index, That Is the Question

In the past decade, there’s been a seismic shift from active to passive management with index funds and ETFs that track the market. With this overwhelming shift from active to passive management, should you hop on the passive investing route, or seek out something more active?

The main reason investors have been flinging money into these funds is cost. Index funds are much cheaper because they’re “set it and forget it” vehicles. Actively managed funds require more attention to maintain, and therefore are more expensive. For an actively managed fund to be more attractive for an investor, that fund would have to outperform a cheaper and comparable broad index fund. Its performance would have to make up the “cost deficit” that comes from the fund’s fees being higher.

With this in mind, index funds have done extremely well over the last decade in comparison with most actively managed funds; however there are four instances where you might want to shy away from having most of your money in broad index funds:

  • In a time of low correlation- A period of low correlation is where not all “boats rise with the tide”. In other words, it’s a time where some stocks are doing better than others and not rising at similar levels due to positive economic indicators or other environmental factors. Low correlation causes broad indexes to have more mixed results, and makes active management more attractive. A July 2017 study by Citi showed that we are in the period of lowest correlation since 2000.
  • In bear markets– When you’re in an index fund that’s riding the market up and down, in a bear market, you’ll be exposed to most of that loss. Most people wouldn’t want to ride the index to the bottom. Consider that a loss of 50% requires a gain of 100% to get back to where you started. We predict that when we have the next bear market, we’ll see a LOT of people pulling their money out of these index funds.
  • If you’ll be tempted to pull your funds out in the event of a market downturn- Emotionally pulling your money out at the wrong time is one of the dangers of having most of your portfolio tied to index funds. The fundamentals of investing are buy low and sell high. What do most people do? They buy high and sell low. Because index funds, by definition, have so much exposure to the volatility of the market, to truly be successful you’ll have to ride it out through the ups and the downs.
  • When you’re close to, or already in retirement- When most people retire, their “income plan” is to systematically draw out a fixed percentage of their portfolio for income. In the past, the generally accepted withdrawal percentage was 4% but in recent years, accounting for the market corrections of 2001 and 2008, Morningstar has revised their recommendation to 2.8%.

In a bear market, if you have a portfolio that is primarily invested in index funds and you’re systematically withdrawing your portfolio for income, that 3-4% of income you once were drawing out of a larger portfolio size will be less income for you every month. You’ll have to make the decision whether to draw the same percentage and live on less or draw a higher percentage and run the risk of depleting your nest egg even sooner. Drawing down your assets when your portfolio is dropping is considered reverse dollar cost averaging.

To index, or not to index, is a tricky question to tackle. When making decisions about your portfolio’s allocation we always recommend you consult a qualified fiduciary financial advisor so you can get advice about your individual situation.