Take a Pass on Passive Index Investing

I just don't understand the attraction to passive investing. The idea is simple enough; use only broad-based index funds and always stay fully invested (save for rebalancing to the target allocation). The proponents of passive investing believe that active management cannot reliably beat the market and they have plenty of data to back up the theory.

An article I read the other night about this investing style got me thinking. The chart below features all of the funds mentioned in the article, showing their performance year to date. I don't think the names matter a whole lot. It could just as easily be a completely different set of index funds, but the result would likely be very similar.

This has been a very aggressive bear market, with just about every stock or fund down a lot. The best-performing fund of those charted below is the DFA US Targeted Value Portfolio ( DFFVX), which is down 30% year to date. The worst-performing fund of the group thus far is the SPDR S&P International Small Cap ETF ( GWX), down almost 50% this year.

The article in question did not give weightings of each fund in the portfolio, but it is reasonable to assume the portfolio is down 35%-40% year to date and close to 45% since the peak in the S&P 500 on Oct. 9, 2007.

As mentioned above, the passive indexers have the data on their side, so I will not win any debates; but how comfortable are you with your account dropping 40% and doing nothing to try to avoid a decline of that magnitude?

The Bear Market Pull
Index funds followed a downtrend this year
Click here for larger image.
Source: Yahoo! Finance

It may be difficult to remember, but the stock market goes up most of the time (72% of the time the stock market has an up year), and so it is reasonable to assume most active managers will lag. However, I'm advocating not for active portfolio management so much as for trying to not go down 40%.

I believe one way to assess the stock market is by looking at the health of demand for equities. When demand is healthy, be fully invested; when demand is not healthy, take some sort of defensive action with your portfolio.

"Some sort of defensive action" would mean different things to different people. Some may want to go 100% cash or sell half or ease out slowly. No path is guaranteed to be 100% correct, but some sort of defensive action when demand for stocks first cracks can help avoid a lot of pain.

I've been a big proponent of gauging health of demand of the S&P 500 by whether it is above or below its 200-day moving average. Taking this theory to an extreme, an investor could sell everything when the S&P 500 goes below its 200-day moving average.

The S&P 500 went below its 200-DMA for good on Dec. 27, when it was at 1488. Today, the 200-DMA is at 1350, so it would require more than a 40% rise from the current level to get back above and therefore to go back in (again with the strategy taken to an extreme that I do not believe in).

The obvious flaw is that missing a 40% move, should it come, would not be ideal; so using this approach may not result in beating the market over the entire cycle but avoiding a big chunk of a huge decline does have some appeal.

Believers in the passive approach to investing can make a compelling argument, but as the chart above suggests, passive indexers have had their heads handed to them. I would say forget what anyone else tells you, you should decide for yourself and do what you think is best for you and then stick to it.

I recently wrote a similar article about 401-k investing, " Be the Master of Your 401(k) Domain." The reason to harp on this so emphatically is because it has helped me and my clients go down a lot less than the market. I read about this in a magazine in 1993; it is simple and has worked. I think it will continue to work for future bear markets. At this point I believe it is too late to take defensive action if none was taken thus far.

At the time of publication, Nusbaum had no positions in stocks mentioned, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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