Index Funds Hold Up Well in Down Year

Many investors who thought their money was better off in actively managed mutual funds during a bear market were disappointed in 2001.  

Investors who scorn index funds often contend that passively managed funds will trail their managed counterparts in bear markets because the index funds can't run away from poor-performing issues or seek refuge in cash during rocky markets. In theory, active managers should have benefited from their ability to discriminate among stocks and build cash buffers in 2001's tough market. But in most fund categories where active and passive funds compete for investor dollars, actively managed funds, on average, trailed their index counterparts. 

It was a rough year for large-blend funds, the category with the most index funds and the most indexed assets. Technology stocks kept falling as their fundamentals kept getting worse. Financial firms that depend on a strong stock market for profits, such as brokerages and asset managers, also stumbled, and fears about patent expirations hurt some large drug stocks. Still, passive funds lost nearly 1.5 percentage points less than their active rivals, though that may seem a Pyrrhic victory to large-blend index investors who, on average, lost 12.4% last year after suffering losses in 2000, as well. 

Low costs and broad diversification helped large-blend index funds, but so did other factors. Standard & Poor's won't add stocks to its S&P 500 index unless they have at least four quarters of operating profits. Consequently, the benchmark, and funds that track it like Vanguard 500 Index (VFINX) and Fidelity Spartan 500 Index , include fewer speculative, profitless technology stocks like VeriSign (VRSN), which have suffered over the last two years. Such stocks are not as widely owned by large-blend funds as they were near the height of the bull market for tech and growth stocks, but enough large-blend funds owned them in 2001 to hurt their performance. 

Broader large-blend index funds like Fidelity Spartan Total Market Index  and Vanguard Total Stock Market Index  (VTSMX) that do include the battered, profitless, technology names still finished 2001 in the top third of the category because these funds track the Wilshire 5000 and include small- and mid-cap stocks, which were among the few areas of the market that performed well last year.   

Index funds in the large growth, mid-cap blend, specialty-technology, Japan stock, European stock, domestic hybrid, and diversified emerging markets groups also lost less than their actively managed counterparts did.

In 13 of the 22 Morningstar stock- and bond-fund categories that have index portfolios, the passive offerings lost less or gained more than their active counterparts last year, according to preliminary Morningstar data. Index funds prevailed in 10 of the 18 equity-fund categories that have passive funds and three of the four fixed-income categories that have index funds.

Many fund categories have just a couple of index funds, but passive funds also prevailed in four of the seven fund groups with 10 or more index funds.

Index Funds Held Their Own In 2001
	Number of Active Funds	Active Funds' 1-Year Return ( % )	Number of Index Funds	Index Funds' 1-Year Return ( % )
Large Blend	1,042	-13.87	172	-12.39
Foreign Stock	761	-21.83	38	-23.47
Small Blend	223	9.14	29	2.86
Mid-Cap Blend	220	-5.06	24	-4.05
Intermediate-Term Bond	592	7.31	19	7.90
Large Growth	971	-23.69	13	-22.60
Large Value	799	-5.33	10	-10.36
Data through 12-31-01.

Categories where index funds gained more than actively managed funds included specialty-real estate, small growth, and short-, intermediate-, and long-term bond.

Where did it pay to have an active manager on your side last year? Actively managed funds, on average, lost less than index funds in the foreign stock, specialty-financial, large value, specialty-utilities, and in both diversified Pacific/Asia and Pacific/Asia ex-Japan categories. Managed funds gained more, on average, than passively managed small value, small blend, and intermediate government bond funds.

Overall, active funds seemed to do better in asset classes like small value and foreign stock,  where solid research can still ferret out mispriced and overlooked securities. This dovetails with past Morningstar studies that have shown managers in these areas often can beat their benchmarks with savvy stock-picking. Wall Street typically doesn't follow small-cap stocks and foreign issues as closely as it does the large, frequently traded, and closely watched companies of S&P 500 and the Dow Jones Industrial Average. So, there's more room in these areas for a talented manager to add value by doing extra research.  

Among bond funds, low costs gave fixed-income index funds the edge. So did a lack of junk bonds, which performed poorly last year as defaults increased. Most of the actively managed funds in the short-, intermediate- and long-term bond fund categories own at least some high-yield bonds, while the index funds in those categories own virtually none. However, enough managers were able to opportunistically shift their weightings of treasury and mortgage securities during their respective periods of strong performance last year to give active funds the edge in the intermediate government bond group.