Stock market sell-off: Takeaways to share with clients

Those hoping that the stock market's recent tantrums will solve the active vs. passive debate will have to wait a bit longer. But advisers who touted the advantages of diversification will have lots to crow about to clients after this sell-off. The Standard & Poor's 500 stock index has fallen 6.66% from its January 26 high, according to Morningstar, Inc., and it fell 4.10% on Monday alone. Not surprisingly, that's pretty much what investors got from index funds that follow the S&P 500. The Vanguard 500 Index fund (VFINX), for example, fell 4.11% Monday and 6.67% since the market peak. From there however, things get murky — and a fund's performance during the market's recent unpleasantness depended on a variety of factors, one of which was its investment style. For example, the Vanguard Value Index fund (VIVAX) has fallen 6.86% since the market peak. The median large-company value fund — half higher, half lower — fell 6.93%. So by that measure, most large-cap value funds failed to beat the index. On the other hand, many of the most popular large value funds with advisers did beat the Vanguard Value Index fund. American Funds Washington Mutual (AWSHX), for example, fell 6.21%, while American Funds American Mutual (AMRMX) fell 5.60%. "The last bear market illustrated that value was misunderstood: People expected the manager to have brilliantly gone to all cash," said Russel Kinnel, Morningstar's director of manager research. That's unrealistic if the fund is always fully invested." Similarly, growth funds fared better than the S&P 500: Vanguard's Growth Index fund (VIGRX) lost 6.29% since the market's peak, while the median large-company growth fell 6.18%. American Funds Growth Fund of America (AGTHX), the biggest large-company growth fund, dropped 5.54%, while Fidelity Contrafund, in the number two slot, fell 5.91%. In part, growth funds may have held up better than value because earnings on tech stocks have held up better than those of bank stocks – a value favorite. In either event, however, active management has yet to prove that it can provide investors in a sell-off. "In theory, active management can respond to market sell off by either exiting positions when management has concerns and using cash to buy favored stocks selling at a discount to fair value," said Todd Rosenbluth, director of ETF & mutual fund research at CFRA. "Passive mutual funds and ETFs cannot do so and must track their index regardless. Unfortunately many active managers do not time the market correctly and to a degree greater than the premium fee their funds charge relative to index counterparts." Some smart beta ETFs did prove to shield investors against volatility, albeit mildly. For example, PowerShares S&P 500 Low Volatility ETF (SPLV) fell 3.59% Monday and 5.55% since the market peak. But again, the biggest factor for many factor funds was where they concentrated their bets. PowerShares S&P Small-Cap High Dividend (XSHD) fell just 3.33%, in part because small-cap stocks suffered less than large-cap stocks during the sell-off. In any event, it's good to remember that low costs may well be the largest factor in long-term outperformance for a fund. By and large, low-cost active funds fare better than high-cost ones.

What really worked for investors? Diversification. Large-company value funds may have had bigger losses in the mini-meltdown, but those are the funds you want to own after a bear market. That point hasn't been reached yet, said Charlie Bobrinskoy, manager of Ariel Focus (ARFFX), which is up 3.88% for the year. "This is nothing like 2008, when we had great companies selling as seven times earnings." But beyond stock funds, diversification was golden. For example. Bond prices rose during the market's mini-meltdown, so a client who had Vanguard Total Bond Market Index (VBMFX) lost just 0.57% since the last market peak. PIMCO Income Institutional (VTBIX) fell 0.58%. Most international funds held up well because of the falling dollar – and, since the sell-off happened late in the day when foreign markets were closed, fair-value pricing may have helped as well, Mr. Kinnel said. And, of course, money funds didn't fall at all – which doesn't seem good in a bull market, but seems great during a bear market.