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Market downturns? Indexing plays a (predictably) passive role

The growth of indexing has been one of the most positive changes for investors in the last 40 years. This simple strategy offers low costs, relative performance predictability and broad diversification. Yet despite indexing's benefits, its growth has sparked debate about its role in a potential market downturn.

As the industry's leading proponent of indexing, Vanguard has a decided view on the topic. "We don't know when the next market downturn will occur or its cause, but research shows there has been no link at all between indexing and past downturns," said Jim Rowley, head of active/passive portfolio research at Vanguard.

Downturns occurred long before index funds existed

A downturn can be defined as either a market correction, which is usually a 10% drop in the market from recent highs, or a bear market, once losses surpass 20% from recent highs.

Although the United States has not experienced a bear market in more than nine years, some critics are speculating that indexing could cause or exacerbate the next pullback. However, research shows that downturns tend to result from a combination of a negative catalyst—typically tied to an event such as a major catastrophe, global macroeconomic news, geopolitical situation, or the collapse of a long-term speculative bubble—and ensuing investor panic that causes a sharp market decline. The chart above shows the numerous downturns that have occurred over the past 90 years. Notably, most occurred before the first index fund was launched in the mid-1970s.

"When you look at history, one of the most severe downturns occurred from 1929 throughout the 1930s. This was caused by the instability of the Great Depression and obviously had nothing to do with indexing, which didn't exist at the time," Mr. Rowley said.

Index funds are far too small in aggregate to rock the market

The belief that indexing dominates the market isn't what's cited as a likely cause of the next downturn. Index fund assets under management have grown from almost zero in the 1980s to about 30% of fund assets globally, but they still constitute only about 10% of the market value of stocks and bonds globally. In the United States, U.S. equity index fund assets represent only about 15% of U.S. market capitalization.

"When measured in proportion to global market capitalization rather than fund assets, one can see that the size of indexing is pretty small," Mr. Rowley said.

As shown in the chart, market downturns have occurred randomly, while the percentage of fund assets in indexed strategies has grown steadily. "This is because downturns happen in response to certain events, but the growth in indexing has happened simply because investors recognize it's a beneficial investment strategy," Mr. Rowley said.

Index fund shareholders were net buyers during past downturns

Pundits have also suggested that the next market downturn will touch off a mass exodus from index funds and exchange-traded funds (ETFs), further exacerbating the decline. If history is any guide, that will not be the case. As the chart below shows, index funds experienced significant cash inflows during the last two bear markets, which were triggered by the tech bust and the global financial crisis.

"Net cash flows into index funds during both of those downturns were positive," Mr. Rowley said. "Therefore it's not logical to claim that the downturn was caused by a stampede to the exits among index investors."

ETFs are not the culprit either

As predominantly indexed products, ETFs have also experienced rapid growth because of their low cost, diversification, trading flexibility and continuous intraday pricing. However, despite their growth in assets, they also have a small footprint relative to the overall market: ETFs accounted for only 13% of global investment assets in 2017, according to Morningstar, Inc.

Furthermore, most ETF trading volume reflects the swapping of ETF shares between a buyer and a seller in the secondary market and doesn't impact the ETF's underlying securities in the primary market. This means that the majority of ETF trading has no impact on the trading volume of the underlying portfolio securities and is therefore unlikely to be a driver of a market downturn.

Research indicates that for every $1 in ETF trading volume on exchanges, less than $0.10 resulted in primary market transactions in the underlying securities. Put another way, over 90% of ETF trading volume doesn't require the buying or selling of the ETF's underlying investments because trading was mostly between investors buying and selling ETF shares.

A participant, not a cause

"Markets went up and down before indexing and they'll go up and down after indexing," Mr. Rowley said. "Without a crystal ball, no one truly knows when the next market downturn will occur. Index funds will, in all likelihood, fully participate in the next downturn. But that doesn't mean they will create it."

Discipline is what it takes to block out the noise, commitment is what it takes to walk the path to financial success and patience is what it takes to reach the goal.

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