The Ignorance Game: Index Funds vs. Mutual Funds

The year 2006 has barely come to an end and the battle goes on. Which one has been the better investment? Index funds or actively managed mutual funds?

Standard and Poor’s reported that the S + P 500 index outperformed 69% of actively managed large-cap mutual funds in 2006. Additionally, the S + P SmallCap 600 outperformed almost 64% of actively managed small-cap mutual funds.

The story goes on to say that over the past five years, the S + P 500 index has beaten 71% of managed large-cap funds. The S + P SmallCap 600 has beaten 78% of managed small-cap funds in the same period.

I have no problem with these numbers, since in my advisor practice we use index funds/ETFs as well whenever they make sense in any given economic environment.

However, there is an ignorant part of that story that totally neglects to point out that markets don’t always go up. What will happen during a bear market?

A casual or inexperienced reader of the above figures could easily interpret them as an argument that index funds are the investment for all seasons. This is not the case. When a bear market strikes, such as the during the period of late 2000 to early 2003, index funds, as well as actively managed mutual funds, will go down sharply.

Some of them were pushed to such low levels that it took a Buy + Hold investor over 5 years just to get back to a break even point. What difference does it make that an index fund may be a better investment when you can lose just as much with it when the bear rears its ugly head?

If a bear market has the potential to devastate an investor’s portfolio, shouldn’t the primary emphasis of investing be to try to avoid that scenario, rather then some chest pounding over a couple of percentage points?

That’s my view, what’s yours?

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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