Vanguard's Davis makes case for index funds even in tough times

The rush of money into big index funds has raised concerns about whether they would still prove attractive in a downturn, an issue taking on more importance especially for industry leader Vanguard Group Inc as its passive products soar in scale. A common view is that while passive funds would face loses in declining markets, active managers could be better prepared because of factors like cash holdings or farsighted stock selection.
Greg Davis, named chief investment officer of Vanguard in July, acknowledged some active funds would fare better. But many active managers, especially in bond funds, have taken on more risk to boost returns and make up for their higher costs, thus setting themselves up for problems, he said. "You could actually see them underperform by even more than what you would expect," Davis said.
Davis spoke with Reuters just after the company held a rare shareholder meeting for fund investors in Scottsdale, Arizona last week. For the 12 months ended September 30 its passive funds took in $335 billion, easily beating rivals, according to Morningstar. Another $6.4 billion went into Vanguard's own active funds, and its total assets are approaching $5 trillion, the most of any mutual fund firm.
Helping Vanguard and other passive fund managers has been the fact that 88 percent of large-cap active managers underperformed their benchmarks over the five years ending December 31, 2016, according to S&P Dow Jones Indices. Mid-cap and small-cap managers fared even worse.
Passive fund performance generally tracks market indexes. At times both fund types decline in value: In 2008 when the S&P index fell over 38 percent in its worst year ever, actively managed large-cap equity funds on average fell by 38.35 percent, according to Morningstar. Index funds fared little better that year, falling 37.67 percent.
Active proponents still make a case for stock-picking. Benchmarks used by passive funds can overweight risky holdings, favoring active managers in down markets, wrote Morgan Stanley Wealth Management's head of investment and portfolio strategies Lisa Shalett in a paper earlier this year. Faster growth or more volatility could also help. "Active managers may soon have an edge," she wrote.