Money Matters: 4 tips for broad market index funds

By Ashley Wilson
The Daily Record Newswire

Passive investing through index funds has become a popular investment strategy since these funds originated in the 1970s. Index funds are an inexpensive way to diversify. They allow investors to buy a market index, like the S&P 500, without actually buying all 500 companies in the index.

Investors have more than $700 billion in index funds, and the market continues to grow with new funds becoming available all the time. However, over the last decade, the strategy of buying and holding a broad stock market index fund has not profited. Buy-and-hold may not work, but investors can still use index funds to navigate a bear market — if they take a more active approach.

John Bogle, one of the most influential people in the investment world, is famous for his convincing claim that investing in a broad market index, like the S&P 500, is far better than buying actively managed funds.

As a finance student in college, I was taught the gospel according to John (Bogle) and Burton Malkiel. Both are proponents of the efficient market hypothesis, a bedrock theory that states that financial markets are efficient and that one cannot consistently achieve returns in excess of market returns. The translation for investors is that they are better off investing in a diversified stock market index fund than trying to beat the market through stock picking or market timing.

It’s no coincidence that index funds’ popularity soared during the 1980s and 1990s, a time period marked by perhaps the greatest bull market for stocks ever. The average annual return in the S&P 500 was 15.8 percent during the bull market that began in 1982 and ended in spring 2000. In a raging bull market, the primary indicator of success is simply participation, which is why indexing worked so well in this market environment.

Unfortunately, bull markets don’t last forever and the current bear market has now been hanging around for more than 10 years. Loyal indexers probably aren’t too happy these days. The average annual return for the S&P 500 index has been -2.4 percent over the last 10 years.

Passive investing through broad market index funds can be a losing strategy in bear markets, when buy-and-hold tends not to work. So what is a Bogle disciple to do? The answer is simple: buy low and sell high. This is easier said than done and requires investors to actively manage their portfolios.

Here are four tips to help investors use index funds to navigate the storm:

1. Don’t allocate all of your stock funds to one broad index. Look at specific industries and sectors. Which sectors are poised to do well in the likely scenario that the recovery is slow? We like the technology and energy sectors.

2. Take advantage of growth trends. We believe growth in the next few years will be slow in developed foreign markets but healthy in emerging markets. And we think U.S. large-cap stocks are trading at attractive valuations, offering a good buying opportunity.

3. Position your portfolio for the most likely scenario. Do you believe there will be deflation or runaway inflation? How will the domestic tax and regulatory environment impact your portfolio? How will interest rate changes impact your fixed income investments? What geopolitical risks could threaten stability in the markets? On the fixed income side, we like municipal bonds, inflation protection bonds, and high quality corporate bonds. We keep bond maturities short to intermediate. We also like hard assets and oil to help protect against a variety of possible risks.

4. Know when to sell. Trends change and you’re not going to be right all the time. Don’t be hasty but know when a particular investment has run its course or isn’t working out like you hoped. Common sense is a key component here.

Use index funds to adopt a more active approach to investing, and beware of becoming too passive in this environment. If this bear market lasts another five to 10 years without any notable progress in the broad market index, you may just give up on stocks completely if you remain complacent in a broad market index fund.

Ashley Wilson, CRPC, is a financial adviser with the Wilson Financial Group of Stifel, Nicolaus & Co. Inc., member SIPC and NYSE, in Portland, OR. Contact her at 503-499-6260 or wilsonam@stifel.com.