When Does Indexing Perform Best?

Shelly H.

We've often discussed the issue of indexing versus active management at Morningstar. To answer Shelly's first question right off the bat, it's certainly not true that index funds are only good in a bull market; they're a good option in any market, if only because their expenses are typically much lower than those of actively managed funds. However, indexing does tend to work better than active management in some types of markets, though not always in the ways you'd expect.

Active vs. Passive
The conventional wisdom is that indexing performs best in a bull market, whereas actively managed funds do better in flat or down markets--what some fund managers like to call a "stock-picker's market." Some empirical evidence supports this claim. For example, the S&P 500 Index beat Morningstar's large-blend category every year during the raging 1995-1999 bull market, then fell behind in 2000 and 2002 before outpacing the category again in last year's buoyant market. To look at it another way, the average large-blend fund trailed the S&P 500 consistently during the bull market, but managed to beat it at least some of the time (though by smaller margins) during the bear market.

A more generalized version of this theory is "Dunn's Law," proposed by researcher Steven Dunn. Dunn argues that when any asset class does well, an index fund will tend to outperform its actively managed counterparts. Thus, Dunn's Law asserts that when, for example, small-cap growth funds are doing well, a Russell 2000 Growth Index fund will outperform the average small-growth offering.

Our own John Rekenthaler wrote about Dunn's Law five years ago when the bull market was still roaring, and he found a significant correlation between how well an asset class performed and how well indexing did relative to active management. Of course, there were notable exceptions to the rule; for example, in 1999, when Rekenthaler wrote the article, all growth categories (large-, mid-, and small-cap growth) handily surpassed their respective indexes. But that was an atypical year in many ways, and Dunn's Law seems to have held up more often than not.

Why should that be the case? There are a number of possible reasons. Index funds are usually fully invested, whereas active managers often hold cash and thus don't take full advantage when the market is charging ahead. Also, active managers often try to time the market in order to boost their gains--a notoriously difficult strategy that tends to hurt more than it helps. Conversely, in a down market, active managers can use strategies not available to an index, such as a value manager buying depressed growth stocks.

Does Size Matter?
Another piece of conventional wisdom is that it's easier to beat an index in a relatively inefficient and illiquid asset class, such as small-cap stocks, than it is in a more efficient area such as large-cap stocks. In early 2002, Morningstar conducted a study that provided some support for this view. Specifically, our analysts examined the nine diversified domestic-equity categories, from large-value to small-growth, and looked at how each had performed relative to the appropriate Russell index over the trailing one-, three-, five-, and 10-year periods.

The results showed that while nearly all the categories had beaten their indexes over the previous three years, nearly all had trailed their indexes over the previous 10 years. Given that stocks had fallen in the previous two years, but had risen steadily in the eight years before that, this pattern generally supports Dunn's Law. The exceptions were the small-growth and small-blend categories, which trounced their indexes over all trailing periods. It's not entirely clear what caused this effect, but it does support the idea that it's easier for small-cap fund managers to beat an index. (Oddly enough, though, small-value funds were the only category to trail their index in every time period.)

This year, despite a fluctuating U.S. stock market, indexing has been the big winner: All six large-cap and mid-cap indexes beat their categories for the year through July 31, 2004.  However, active management has continued to excel in the small-cap arena; the small-blend and small-value categories both beat their indexes through July 31, and small-growth just barely trailed the Russell 2000 Growth Index.

I don't want to predict whether these patterns will continue, because the market has a way of going off in new directions once you think you've got it figured out. I also hesitate to make any blanket statements, because there are some active managers in just about every category who have clearly added value over time. But as a general rule of thumb, if you really want to try your luck with an actively managed fund, history has proved that the small-cap arena would be your best bet.