Why Index Funds Underperform in Down Markets

Here’s a fascinating description from Economist Burton G. Malkiel that explains why mutual funds (which is to say, active investing) outperform index funds in down markets (emphasis added):

Now, let me put an admission into this that I have found in my own empirical work. In markets such as last year’s, which was down almost 20%, active managers underperformed, but by a little less. In other words, in down markets, the deficit of active management is a little bit less compared with the index fund. The reason is that all mutual funds keep a cash reserve of 5% to 10% because there could be redemptions. Even index funds have a cash reserve of 5% to 10%. The difference is that the index fund, because it has to track the index, offsets that cash reserve with a long position in the futures market. So, the index fund is always 100% invested, whereas the average active manager might be 92% or 93% invested. That explains whatever difference there is in down markets. There is a difference, but it isn’t because people pick better stocks in down markets than up markets.

A futures contract is an agreement to buy or sell the underlying asset (in this case shares) at a predetermined price and date in the future. This strategy allows index funds to maintain a fully invested position, even when cash reserves are held for possible redemptions.

In the Barron’s interview (link available below), Malkiel doubles down on his enthusiasm for index funds when the reporter asks him to name stocks that he favors:

I’m not going to talk about individual stocks because my ideas of which stocks to buy are no better than anyone else’s. And frankly, they have been no better than my blindfolded chimpanzee.

Click on the link below for an interesting interview.

index funds mutual funds stock market stock market performance
Source: Lauren Foster | "Economist Burton G. Malkiel Still Favors Index Funds Over Stockpickers. Here’s Why. " | Barron's | 02/09/2023 | Visit