In the decade leading up to 2020, index fund investing felt like smooth sailing. Then, everything suddenly changed. In March of 2020, the S&P 500 Index suffered a drawdown of 34% from its recent peak as investors panicked over the coronavirus crisis. What happened next was just as jarring: even as the global economy languished, stock markets rebounded sharply. Indexes roared back to even for the year by the beginning of June of 2020, just in time for summer.
How should index fund investors think about what has taken place this year? To help answer these questions, here are three things index fund investors should consider in the aftermath of 2020’s roller-coaster start.
As heavyweight boxer Mike Tyson once said, “Everybody has a plan until they get punched in the mouth.”
In the first quarter of 2020, index fund investors got punched in the mouth. Many abandoned their plan of gradually investing (known as “dollar-cost averaging”). Instead, they switched to low-risk investments such as bonds. This left them unable to benefit from the rapid recovery that followed. Did you stick to your plan?
The truth is, it is difficult to assess one’s risk tolerance without experiencing a real-time drawdown. Many investors who had believed that they would hold on to or even buy stocks if they declined by 30% found themselves too uncomfortable to stick to their plan. These extreme declines provide an opportunity for investors to perform an honest self-assessment.
What have you learned about your willingness to bear risk?
The recent market volatility has also demonstrated that willingness and ability to bear risk are not the same thing. In the depths of the downturn, many investors were forced to liquidate their index funds. They needed the money to pay taxes, fund retirement, or finance their business that was struggling due to the pandemic. Retirees with the majority of their assets invested in stock index funds were particularly hit hard. They watched as their savings evaporated over a few short weeks. These events should cause us to reconsider our asset allocation (the mixture of stocks, bonds, and other investments) and whether it makes sense given our situation.
An important benefit of index funds is their liquidity. Because they tend to hold baskets of highly-traded stocks, they can typically be liquidated quickly without losing significant value. But when everyone is heading for the exits at the same time, this can put negative pressure on prices. If you anticipate that you may need to withdraw money during a downturn and you want to own an index fund, it makes sense to own a fund made up of larger, more liquid companies.
Finally, given the above considerations, it may be time to consider different index fund options. It may surprise you that there are more stock indexes than publicly-traded stocks in the world.
As a rule of thumb, index funds that focus on stocks of smaller, foreign, or more cyclical companies tend to be riskier, but carry the prospect of potentially higher returns in the long run. These may be suitable for investors with higher risk tolerance and a more bullish (optimistic) outlook.
For the more defensive-minded, index funds that invest in large U.S. companies, such as the S&P 500, tend to be less volatile compared to the above options. Balanced funds, funds comprising a mix of stocks and bonds, can also be a way to provide downside protection.
There are also index funds designed to produce less volatile returns. However, they don’t always perform as advertised. For example, the S&P 500 Low Volatility High Dividend Index seems like it would have held up well amid the market chaos. Not so. Its max drawdown in March of 2020 was -41%, compared to -34% for the S&P 500 Index.
Lastly, active management can be an effective approach. Strong active managers can take advantage of short-term opportunities caused by big market moves to outperform index funds. However, our research has shown that it is difficult — though not impossible — to identify active managers that can consistently outperform net-of-fees. This is particularly true in widely-trafficked areas such as large-cap U.S. stocks.
A seasoned investment advisor should be able to help sift through the available options to construct the best portfolio to meet your objectives given your risk tolerance.
2020 has been a year for the record books — and we’re not even halfway through yet! As we’ve experienced, sometimes investing can feel like a roller coaster ride. With appropriate consideration given to willingness and ability to bear risk, as well as different investment options, we can avoid motion sickness and ride through the inevitable ups and downs.
This article was written by Matthew Lui, CFA, CAIA, Vice President, Investment Research. As a member of Canterbury’s Research Group, Mr. Lui is responsible for sourcing, evaluating, and monitoring traditional, long-only equity managers. Mr. Lui serves as the chair of Canterbury's Global Equity Manager Research Committee and the vice chair of the Hedge Funds Committee. He also sits on the Capital Markets Committee. Prior to joining Canterbury, Mr. Lui was a trader and research analyst at Knightsbridge Asset Management. He received his Bachelor of Arts in economics from University of California, Berkeley. Mr. Lui is a CFA® charterholder and a Chartered Alternative Investment Analyst.