Managing expectations is a crucial aspect of successful investing. With today’s long-running bull market having proven its resilience in the face of political, economic, and virtually every other type of threat over the past eight-plus years, it’s become dangerously easy for investors to expect the good times to continue indefinitely.

Perhaps more than any other group, index-fund investors are particularly at risk of complacency due to their passive approach to their investments.

The golden age of indexing

Index-fund investing has been all the rage in recent years. According to Morningstar, while there is still more money in actively managed funds than passively managed funds ($9.3 trillion vs. $5.3 trillion, as of the end of 2016), the tide is shifting rapidly. In 2016 alone, total actively managed fund assets declined by $285.2 billion, while passive fund assets increased by $428.7 billion. That trend has been in motion for several years now.

The dramatic shift to index funds has been fueled by a pair of powerful forces. The first is the recent performance of passive index funds relative to actively managed investments. Active management, taken as a whole and after accounting for its typically higher fees, has failed to beat its benchmarks in most cases. This performance shortfall has been especially vivid during the current bull market, which now extends back the better part of a decade. As a result, it’s been easy for investors to become convinced that passive investing is the “simple” way to succeed.

Second, the dominant financial advisory model has shifted so as to align advisors with indexing. Over the past 10-15 years, most advisors have shifted away from the old commission-based model in favor of a “1% of assets” wrap-fee approach.

While in theory this unties an advisor’s hands to recommend whatever he or she thinks is best, in reality the overall fees charged within the portfolio are a significant constraint. With the advisor’s fee already at 1% or more, it’s difficult for most advisors to recommend adding substantial active-management fees on top of that. Putting a client in a suite of low-cost index funds is much more palatable, as it keeps the overall expense ratio of the portfolio lower.

Not surprisingly, the brokerage house that invented the index fund, Vanguard, has been the biggest beneficiary of index-fund enthusiasm, with nearly $300 billion flowing into its funds in the first nine months of 2017. The firm now has $4.7 trillion under management.

Daniel Wiener, editor of the Independent Adviser for Vanguard Investors, a newsletter that follows Vanguard funds, told The Wall Street Journal there’s only one thing that could stem the tide: “I don’t think that there’s much that changes these flows until we have a negative market. I can’t tell you when that happens, but when it does there will be a lot of very surprised investors.”

Caution is advised

And there’s the rub for index-fund investors. Having bought into the narrative of index-fund superiority, and having enjoyed a relatively smooth upward ride since 2009, any change of market direction likely will come as a shock. Concerns are growing that index-fund investors in particular may be in for an especially rough ride when the market changes direction.

Josh Brown, CEO of Ritholtz Wealth Management and author of the widely-read blog The Reformed Broker, wrote this in May: “What will happen into the teeth of the next 20% stock market decline? Here’s what I would guess: Vanguard loses 10-15% of its AUM [assets under management], an enormous outflow in a very compressed period of time as newly-minted passives realize that they’re not quite cut out to be passive after all. The pain will prove too much for many recent indexing dilettantes who thought this was easy.”

There are at least two specific reasons to believe index-fund investors may suffer disproportionately during the next bear market:

  1. Index funds are always fully invested.
    By definition, index funds are designed to mimic a particular index, such as the S&P 500. As such, they typically allocate all of their assets to the investments that compose their benchmark. Holding no cash gives index funds an advantage over actively managed funds during bull markets, but that can turn into a disadvantage during a bear.

    Actively managed funds, on the other hand, typically keep 2%-4% of their assets in cash to handle normal customer cash flows without having to disrupt their portfolio to cover redemptions. In addition, some managers like to have some cash on hand to take advantage of buying opportunities that present themselves.

    Taking that a step further, some active-fund managers have increased their cash holdings as a defensive position against future market declines, noting the market’s rich valuations. For example, among the current recommended funds used in SMI’s Stock Upgrading strategy, at the end of June, Baron Discovery had 7.6% of its portfolio in cash, while Selected International had a whopping 22.3% cash allocation!

    Keeping some assets in cash, and having the freedom to shift more to cash at times of (or in anticipation of) market stress, can help actively managed funds better navigate declining markets. Of course, how well actively managed funds weather a downturn also depends on the nature of the particular bear market.

    As the table at right shows, Stock Upgrading (the SMI strategy that relies most heavily on actively managed funds) suffered less-severe losses than either the S&P 500 index or SMI’s index-fund strategy (Just-the-Basics) in the last two bear markets. Upgrading’s performance advantage was far greater in 2000-2002, due to that bear’s longer length (which allowed Upgrading more time to align with the longer-term trend) and the fact that some types of stocks held up better than others.

    In contrast, during the 2008-2009 bear market, virtually all stocks fell in unison, leaving few options (other than cash) for active managers to avoid the devastation.
     
  2. The market’s narrowing breadth may signal pain for indexers.
    Breadth refers to how many stocks are participating in the market’s gains or losses. This bull market’s relentless march higher has been disproportionally driven by a small number of stocks the past few years — specifically Facebook, Apple, Amazon, Netflix, Microsoft, and Google.

    The S&P 500 index is the most popular index among passive investors. As of August, FactSet reported that one-seventh of all ETF assets tracked the S&P 500. Because the S&P 500 is a cap-weighted index (meaning each stock’s influence on the index depends on its size, as measured by total market value) this handful of large, yet still rapidly growing, stocks have an outsized influence on the index’s performance.

    Goldman Sachs reported in June that Facebook, Apple, Amazon, Microsoft, and Google (Alphabet) collectively made up about 13% of the value of the S&P 500. However, their strong performance had driven 40% of the S&P 500 index’s growth for the year to that point, adding some $660 billion in value. While most passive investors likely believe their returns come from a large, well-diversified collection of stocks, the reality is their returns have become increasingly driven by a relative handful that have grown disproportionately within that index.

    The concern for index-fund investors, then, is simply this: When the market changes direction, those high-flying stocks may experience significant outflows, taking their value and the value of S&P 500 index funds down disproportionately. It’s common for the fastest-growing stocks during a bull market to decline the most during the subsequent bear market. The difference this time is millions of new passive investors may exacerbate this “normal” selling as they see the value of their indexed holdings plummet, creating a self-perpetuating, vicious cycle.

What does it mean for SMI investors?

Here are a few thoughts to consider, depending on which of SMI’s three core strategies you use.

  • Just-the-Basics
    As the above table shows, JtB fell right along with the market during both bear markets. In fact, its small-company and foreign stock holdings lost a little more than the S&P 500 during those periods, which isn’t unusual during stock-market declines.

    JtB is ideally suited for investors with money in taxable accounts, and market conditions don’t change that fact. JtB investors with a long-term perspective may want to continue on that path, but all JtB investors would be wise to periodically consider their risk tolerance and mix of strategies. If nothing else, this will help ensure that their stock/bond allocation within JtB remains appropriate. (You can find SMI's risk tolerance quiz and guidance for determining your optimal asset allocation in the Start Here section of our website.) 
     
  • Stock Upgrading
    As noted earlier, Upgrading helped SMI members weather the past two bear markets, with a substantial performance benefit during 2000-2002. Just as no one knows when the next bear market will arrive, no one knows how severe it will be or the exact shape it will take. Upgraders with a long time horizon may be content to stay the course, understanding that the strategy may spare them some of the agony a bear will bring. For those with shorter horizons or weaker stomachs, this would be an appropriate time to consider diversifying strategies, adding an allocation to DAA to build in some downside protection. (Read Higher Returns With Less Risk: The Best Combinations of SMI's Most Popular Strategies.)
     
  • Dynamic Asset Allocation
    Going all-in with DAA would provide the best protection against a bear market, as the table shows. However, moving money from Upgrading to DAA may also mean missing out on some future gains should the bull market continue for an extended period.

If you do decide to focus on DAA, you will still need to manage your expectations. Remember that DAA, like Stock Upgrading, is a trend-following strategy. As such, it won’t avoid all losses at the beginning of a bear market. For example, when the market lost -4.2% in November of 2007, DAA investors would still have had two-thirds of their portfolio invested in stocks and would have had losses of -3.1% that month. However, DAA shifted out of U.S. stocks the very next month and stayed out through the remainder of that bear market, saving investors from tremendous losses. (For more on how DAA performed during the last downturn, read How Short-Term Thinking Can Derail Long-Term Success.)

Note that this article isn’t meant to suggest that SMI believes a bear market is imminent. We have long held the position that the future direction of the market is unknowable. That said, as we have been reminding readers lately, no bull market lasts forever. Eventually this one will end, as they all do, so manage your expectations accordingly.