3 Ways Index Funds Make Gains in a Bear Market

Index funds “don’t work” in bear markets… or do they? In this episode, I break down three powerful ways index funds can still create future gains when markets are falling From dividend reinvestment to rebalancing and dollar-cost averaging. 

If recent market movements have you questioning your strategy, this is a must-listen reality check. 

If you have a question, suggestions, or a topic you would like us to cover, please send an email to: podcast@foxplan.nz

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The information shared on The Dollars & Sense Podcast is general in nature and does not consider your individual circumstances. Dollars & Sense exists purely for educational purposes and should not be relied upon to make an investment or financial decision. Tim Ellis (FSP778196) and Brodie Haggerty (FSP778174) are both Financial Advisers providing advice on behalf of FoxPlan Ltd. FoxPlan Ltd (FSP39630) is a licensed Financial Advice Provider. Important information can be found at www.foxplan.nz/disclosure 

Transcript

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Index funds cannot make returns in bear markets. Have you ever heard that before? Is it somewhat true? Well, this week's episode, I'm going to be talking through three different ways that index funds can actually make gains during bear markets. Welcome back to another episode of the Dollars and Cents podcast. This week you're listening to Just Myself, which is Tim Alice. I'm a qualified financial advisor working with an investment company in Wellington called Foxplan. Now, the purpose of this podcast is to increase the financial literacy of our listeners. Just before I get underway with this week's episode, I just want to be very, very clear that everything I'm going to talk through today is meant to be for um education purposes only. It's not designed to be specific financial advice. Please, we urge you to seek the relevant professional before making any financial decisions. With that out of the way, as I said in the intro, a common sentiment is index funds cannot make gains during bear markets. What people are really getting at there is if you're invested in a diversified uh index tracking fund and the global markets or the markets of the fund that you are invested in are all on average going down, an index fund cannot make returns. The only way out of this is to be out of index funds and being in concentrated funds or picking stocks that are going to win during bear markets. Well, I want to challenge that a wee bit and actually go under the hood a little bit on three different ways that uh investment funds or index funds can make gains during a bear market. Just before I get underway with the first way that uh that can occur, I I want to be very clear. I was tricky with my wording there, and I was tricky on purpose too. I said that index funds can make gains. I did not say they can definitely go up in value. I'm talking about how an index fund actually works and why you could be excited about uh uh bear markets and and and what can occur that can turn into future growth. The first point I want to make is dividends. If you are in an index fund that's tracking the SP 500, a vast majority of the companies in the SP 500 pay a dividend. This theory is is also true for individual stocks. If uh if I have listeners that own uh individual stocks, some of those individual stocks may pay dividends. Here's what actually happens when uh a company's value uh goes down but still pays a dividend. And I'll also give some examples of uh what's actually happened in the uh SP 500 index over other major market corrections. But essentially, to understand this uh this theory or this idea, uh, a yield of uh a stock is simply the dividend paid divided by the price of the stock. So what that means is when the price of a stock goes down, if the dividend paid was stay the same, then technically the yield has gone up. Not because the dividend has increased, but simply because the price of the stock has gone down. So where this becomes most powerful was usually during the worst market times. So during 2008, um prices massively went down. Yields went significantly up. So if you were receiving a dividend on any of the shares that you owned and reinvested those dividends, during bear markets, those dividends were actually buying more shares at cheaper prices, which meant you had a higher income yield. If you're following what I'm saying here, essentially the worst markets for your portfolio value are often the best markets for your future returns because that's when your dividends are working the hardest. Let's look at some real examples with real numbers. If we can go back to the 2008 global financial crisis, the the SP 500 fell about 37% in the year 2008 alone. And whilst stock prices on average, or that the index itself fell by 37%, peak to trough decline was actually closer to about 50 to 60 percent. However, the reality of the dividend, the dividend yield in 2007 before the global financial crisis of the SP 500 was about 1.87. In 2008, the dividend yield was 3.23. Uh at the peak of the panic in in early 2009, yield actually pushed about four percent. So that's a effectively, you know, you you could argue a hundred percent increase in the yield for any stocks owned that were paying dividends. Uh on average, of course, I'm talking. So here's the nuance. Actual dividend payments across the SP 500 companies were indeed cut by 20 to 23%. But because of this shift in uh the value of the stocks uh being a lot steeper than the decrease in the dividends paid, the yields actually increased. Dividends didn't fall quite as fast, but prices fell much faster. So the income you were reinvesting actually became more powerful. That's one example. That's the 2008 global financial crisis. If we look at the dot com crash, uh 2000 to 2002, uh so the dividend of the SP 500 in the year 2000 before the crash was 1.22%. In 2002, it was 1.79%. That means that that there was actually a 45% increase in yield. So dividends were more stable uh than they were in 2008 during this time. So less financial system stress and fewer cuts on dividends. Companies do not like to cut dividends. It sends a signal to the market that the company's in trouble. Companies will quite often do everything they can to make sure that dividends stay the same or even better, increase. It sends a strong signal as that they're going through a market correction. What about a more recent example? COVID. COVID-19. So during COVID-19, the S ⁇ P 500 dropped about 31% in just two weeks. The yield increased, albeit rather temporarily, but that was purely due to the price drop effect. So uh, you know, cuts were much smaller than 2008. The recovery was fast, so the yield actually normalized pretty quickly. This serves as a pretty darn good reminder that dividends are far more stable than prices, but still tied to the same economic shock. The thing these three examples have in common is uh, well, the message that you can take from all three is that dividends are stickier than prices. Uh stock prices react to the stock market and investor sentiment. Uh dividends are more tied to the fundamentals and earnings of the company. They can take a lot longer to shift and change and fall uh much more faster than uh the sentiment can drive investor behavior. Uh stock prices are almost always driven uh to some degree by investor behavior. Uh and again, companies do not really want to be sending signals by changing their dividends. So, what this means is if you uh if the the value of the stock that you own, or uh if we're talking about the SP 500, that's about 70% of the companies in the SP 500 pay a dividend. If they've all on average gone down, but the dividend was to stay the same, the dividend that you're receiving and then reinvesting will be buying more shares than if the stock price had not fell. That's where genuine growth actually occurs and happens in an index fund, if well managed, I might add, um, even during bear markets. In fact, this very point that I'm making with dividends has a big uh more dramatic effect on the future gains of the portfolio during market corrections when prices have fallen even sharper. Okay, enough about dividends. Let me move on to the second way that index funds can make gains during bear markets. I want to talk about rebalancing. There's two different types of rebalancing that I'm going to address here. One is rebalancing different types of assets, the other is rebalancing equities, so one asset, but just between different asset classes and different types of equities. I'll start with the rebalancing different assets. Essentially, what a rebalance says is say you have asked for a managed fund that is aiming to hold about 80% of the fund in shares, be they globally diversified, large cap, small cap. I'm not being specific in this example. Just 80% of the fund itself is invested in shares, while the other 20% are holding bonds and term deposits and cash. Very different assets to shares, very different levels of volatility. What the act of rebalancing says is as those uh percentages of uh allocation to uh equities and other shift with market volatility, what I'm saying here is if shares in that portfolio all lost their value by 50% due to a market correction, you would move from having an 80-20 split to having something a little bit closer to a 40-60 split the other way. If unbalanced, that's what the fund would actually look like. Whilst the value of all the shares have gone down, all the term deposits that were on fixed interest or bonds that were on fixed interest may have actually increased, and that's changed the asset allocation of the fund that you're in. What rebalancing says is on a set period of time, we're gonna take the whole fund into consideration. And if the uh the shares have gone down in a value that's shifted the asset allocation away from 80% down to 65% or whatever their threshold is, they're actually gonna sell some of the term deposits or use some of the cash that's in that fund to repurchase shares. What that means is if uh share markets have gone down, your fund uh within itself will actually be purchasing more shares. They'll be taking gains from the other assets that have appreciated in value. So using what's gone well, getting rid of it, and using it to buy the assets that have gone poorly. Uh on the other hand, uh shares could have gone the other way, which they more often than not uh do. They win more than they lose, as long as it's a well-managed fund. I again must add that caveat in there. Um so if uh uh equity returns uh grow the fund and now you have a 90-10 split instead of the 80-20 that you asked for, a rebalanced fund would then sell 10% of those shares and use it to reinvest back into term deposits and get you back to that 80-20 split. So it would be realizing the gains of the share market and getting you back to the the split that you asked for. Today's episode is focusing on how a fund can actually make gains uh within a bear market, not a positive market. Well, what this actually looks like is of course, if you go and check your balance, it'll tell you the value of your fund has gone down. But if you go and check the value, uh the number of shares that you own, that number will be increasing. It's just that the the value of the shares within the fund are lower than they were before. That's why you're seeing a lower balance. However, let's go back to looking at real-life examples and using the same different uh uh market corrections that we used before. Let's look at the SP 500 during the global financial crisis. Again, down 37% in 2008. At the same time, US aggregate bonds actually grew by 5%. So if you originally had an 80-20 portfolio and then that occurred, you would end up with something like a 65 to 70% in equities and the other 30% sitting in bonds and and term deposits. So what a rebalance would do is say now the fund is going to sell those bonds, which are the winners, they're gonna buy the equities, which were the losers. Why this matters is the real outcomes. From March 2009, which was the bottom of this market correction, the SP 500 rebounded 68% in 2009 alone. By selling those bonds and buying more shares, that's more shares that were affected by that rebound of 68%. Had have you not rebalanced and thought, well, the market's not ready yet, I'll just hold off, you would have missed out on 5% of your fund being exposed to that 68% return. It forced buying at the bottom, it increased equity exposure right before the recovery. Now, I look, I know it's easier said than done. If you're doing rebalancing on your own, you're a do-it-yourself investor, there is the psychological shift that has to occur. I mean, in 2008, rebalancing meant selling the only thing that felt safe, which is bonds, and buying the thing that everyone was terrified of, which was shares. Not always easy to do when human emotion gets in the way. However, some managed funds uh will have that built into the managed funds where they're mandated to do rebalancing and human emotion could be taken out of that. As said time and time and time again, humans are not good investors. We are not built for it. Take a look at the COVID example that we used before. SP uh down 31% in over a matter of weeks. Bonds, they didn't even move at all. It was such a short time period. But uh even though bonds didn't move, the 80-20 asset allocation you would have asked for has shifted dramatically. Uh if you were able to sell some of those bonds and cash and term deposits and buy companies shortly after that two-week sharp decline, then we all know that three months later the market had completely rebounded. Again, that's another portion of your fund that would have appreciated the value of a 31% gain on the way back up. At the end of 2020, the SP 500 finished 18% up. So it's not just about the rebound on the way back up, but staying disciplined to your approach would have seen that uh a lot more shares were exposed to the 18% return that occurred throughout the whole year. The thing about a mandated uh rebalance is rebalancing doesn't really wait for uh confidence, it acts before the recovery is obvious. Now, I do need to be uh two-sided here and and and be fair uh to the real stats and data as well. Rebalancing doesn't dramatically increase return on uh on on its own, but it it does reduce volatility, it improves risk-adjusted returns, um, systematically enforces buy low sell high. Uh over the long periods, portfolios that rebalance on a regular basis tend to uh avoid exposure to overpriced assets, and uh that can be attributed to adding a 0.2 to 0.5% year increase in uh in behavioral alpha. Uh that sounds small, but you know, if you're invested over 20 years, it actually has quite a large effect. It's not about beating the market, it's about not sabotaging yourself. Okay, so that was all about rebalancing a fund with using two very different assets that uh behave completely differently, those being equities and bonds. Now let's take a look at rebalancing within a portfolio when we're only rebalancing the equities. What I'm getting at here is a uh a fund will be made up of a selection of shares and equities that the fund aims to buy based off the investment philosophy of the fund manager. I'm gonna use the example of a fund that I use myself. Okay, so uh the this fund that uh I use within my portfolio, it uses the evidence that uh small cap companies uh and value stocks tend to outperform large cap companies and growth stocks over a long period of time. That's what the evidence suggests. And so what they're aiming to do is not exclude large cap companies and growth companies, but actually just rather tilt and engineer a tilt towards putting more money in the basket of companies that are a smaller cap uh and value uh shares to buy. Uh that way they expect a higher expected return without missing out on getting all the gains of some of the larger cap companies, which to be fair, over the last 10, 15 years has have been completely outperforming, those being the likes of Google and Microsoft and Apple and the companies I've mentioned on the podcast before, of course. But what rebalancing within a portfolio says is if we're buying these small cap, unknown value stocks that nobody's heard of before, then they start to grow. They've got a lot of room to grow. And as they start to move from small cap companies up to large cap companies, once they cross over a threshold, rebalancing would say, okay, the company's had the gains, will now sell some of that company and redistribute though the proceeds from those gains back down to another small cap value company that might do the same. Rinse and repeat, rinse and repeat and rinse and repeat, meaning that your the fund is always uh overweighted to small cap value companies. But as soon as those companies have actually made the gains that we expect, they're going to start taking the uh investment uh the overweighting away from that company as it's now turned into a large cap. And that means we're realizing some gains. Once gains are realized and then reinvested, if done in a systematic and disciplined way, uh we can have a higher expected return within the portfolio. So even though you might be looking at your balance um, if you're in this particular fund, that is, and seeing the value of your fund going down, the fact is uh if we're sticking to the mandated rebalancing, the fund is actually doing work. It is actually taking gains and uh reinvesting those into future gains. That that means that they're able to buy more shares in those uh lower cap value companies, uh, the ones that we expect a better return from. And that can happen without you even putting more money into the fund. It's simply happening from selling the winners and buying the next winners. If you're attempting to do this without a uh a mandate or an automated system and doing it yourself, uh it once again brings in the human emotions side. Let's say that you invested a long time ago in a unknown small cap company that had actually shot the lights out and provided you so many gains. And when you've checked your balance, it's a lot higher purely because of this one stock that you've owned. It might be very difficult to sell that stock. You can become emotionally attached to it and attribute a lot of your success to the stock and feel pretty bad about saying goodbye to the, I don't know, perhaps it doubling again in the next 10 years. So uh doing a rebalance within a fund on your own can be quite tricky. Having a fund that does it systematically, backed by evidence and um uh on a mandate removes that human emotion from it. Okay, time for the third and last way that an index fund can actually make gains during a bear market. Unlike my uh caveat before where I said I said gains and not a higher value, uh, well, this time it could actually be both. What I'm gonna be talking through is the uh dollar cost averaging effect. Uh I've harped on about this plenty of times before on the podcast. However, I've also harped on about it to a lot of clients. That does not stop them from failing to have the urge to ask, is now really a good time to be investing with what's going on or what could happen in the coming months? So I thought maybe a timely reminder about how dollar cost averaging really works. If you are regularly contributing to your investments, uh, in this case, a managed fund. In fact, in this case, I'm going to use KiwiSaver and I'm going to be giving precise examples to my very own KiwiSaver fund that I'm in. When you're putting money into your KiwiSaver fund, you're buying units, the unitized funds. And so the value of the unit is dependent on the assets that make up the unit, meaning the companies that are within the fund. I can go on to my Kiwi Saver and see the unit price on any given day. I can also look at historical data to see what the unit price was on previous days. What this means is I can see exactly how much I have paid for each unit over different cycles in the market. People are more often happy about their KiwiSaver fund when they check their balance and see that the dollar figure is higher than it was before and it's growing. The fact is, uh you could own the same amount of units, and the next day your value could be higher, simply because the value of the companies that are behind that unit are worth more, and that's why you'll see a higher balance. But you might not have actually purchased more units. What happens in a bear market, if you didn't put any more money in your Kiwi Saver, you would still own the same amount of units, but they would have a lower value, and therefore your balance will show a lower balance. But what happens during a bear market when unit prices are cheaper? Is putting in the same amount of money that you've been putting in every single paycheck is now buying more units than it used to buy. Looking at my very own Kiwi Saver, I've looked at the unit prices over the last couple of years. Um the uh the the peak of the last couple of years was in mid-Jan, um, and the peak was uh 16.68. That is the highest the unit price has been. The recent low is unsurprisingly, right now, which is late March, has dropped down to$15.61 per unit. So that's roughly a uh negative 6.4% drop. It's not a crash, but it's enough to uh make some people feel a little bit uh uncomfortable for most investors, I'd say. Most investors would start to say my KiwiSaver is is going backwards right now. And from a surface level interpretation, that'd be absolutely right. The balance is going backwards. However, if I'm putting in$1,000 every contribution to KiwiSaver at uh the peak of the unit price, which was 16.68 per unit, I would be buying 59.9 units that week that I contributed to KiwiSaver. If I was only buying them at the current low, which is 15.61 per unit, my thousand dollars now buys 64.1 units. You know, I I'm getting effectively 7% more units every time I'm uh investing without changing the amount of money that I'm putting in. I will be accumulating more units now than I was when it was at its peak in uh mid-Jan in 2026. Why having more units matter is if you can trust that uh the last hundred years of history will repeat itself yet again, markets have always returned. What's going to sh uh make up the balance of my KiwiSaver fund will be the number of units that I own times the price of each unit. So if I trust that unit prices over a long period of time will increase, having more of them will add to how big my balance will be. So I want to be buying as many units as I possibly can with every contribution before I need to start using the money. In my particular case, you might have worked out from my voice, I've got a few years to go before I'll be accessing KiwiSaver. But that was uh only a relevant example. Let's scale it up now. Let's look at a 20% market drop or a 20% drop in unit value. So if we have the starting price of 16.68, which was the high in mid-Jan, and we have a 20% drop, uh uh the unit price would go down to 13.34. Completely possible. Again, before I uh at the height, my thousand dollars will buy me 59.9 units. Um, but after a 20% drop, I'll be buying 75 units. That's 25% more than it was mid-Gen. If we have a 40% drop, then uh again, using the starting price of 16.68 per unit, dropping all the way down to 10.01 per unit, I will now be buying 99.9 units with my thousand dollars. That is 67% more units than what I was getting before at the market peak. Having said this out loud, I'm starting to get concerned that I've said the word units too many times. I've used too many different numbers. I might not have said dollars at the end of some of those numbers. So I think what I might do is actually just put this in a a bit of an analogy that might help make a little bit more sense or make it a bit more simple. Let's imagine that my goal was to fill up a tanker that's sitting in the backyard of my house and I want to fill that tanker up with petrol. I'm gonna need 10,000 liters of petrol before I retire. That's what I'm trying to achieve. So now let's imagine uh I'm not gonna buy all of that petrol at once. I'm gonna buy a thousand dollars worth of petrol every single week. Let's say fuel price is$2.50 a liter. Now, that seems a bit hard to say right now because uh as I was driving in here, uh my petrol, which is$95, is turned into$3.61 a liter. For the American listeners that uh I I have a strong following of, uh that that's a pretty big jump in price, and it's a heck of a lot more than you guys are paying. So rejoice in that fact. But anyway, back to the story. Let's say fuel is$2.50 per liter. My$1,000 will buy me$400 liters that I can put into my tanker to fill it up. Now let's say the price of fuel drops. That'd be a nice idea right about now, wouldn't it? That same thousand dollars is gonna buy five hundred liters. That's a hundred liters more than I was buying the week before. Now let's imagine that prices drop even further. Fuel crashes to a dollar fifty a liter. Now my thousand dollars is buying me six hundred and sixty-seven liters instead of the four hundred it was buying at the top of the market. I will be filling up my tanker a whole lot faster. Now, might I remind you that if we look at the historical price of fuel, it has had a long-term trend rather similar to the direction of the long-term trend of global equities, and that is up. I need to trust that the price of fuel in the future will be more than the price of fuel now over a long period of time. I do trust and believe that uh when I get when it comes to global companies, stocks, equities. That's why this analogy is uh connecting the two together. Instead of buying liters, you're buying units within a Kiwi saver. The value of those units I trust to be higher than they are when I'm buying them today. I can't afford to buy all 10,000 litres of petrol today. So I'm gonna have to buy them periodically over the the the next 30 years. So when I notice prices are down, I don't get upset that the fuel that's already sitting in my tanker is now worth less money. I get more happy about the fact that uh my money is buying more liters than it was before to put in the tank with it. That's gonna be worth more money in the future. The problem with this one is outside of Kiwi Saver that is already automated through uh employment or uh direct debit for the uh self-employed, uh, if you're doing this yourself in your own managed funds, most people do the opposite. They stop buying when prices have dumped, you know, which is like deciding to stop filling your tank when fuel goes on sale. It does not make sense. But again, humans are not built for investing. We are not naturally good at it. That's by having a disciplined approach to dollar cost averaging and uh regular contributions, not changing the plan when the markets go upside down. That's where gains are truly made with successful investing. Okay, so I've again covered off the three uh ways that an index fund or investments can make gains during bear markets. I've really enjoyed going through this episode. I think it could be a very good resource for, you know, I'm sure I'll have some clients coming through. I'm not sure what's ahead of us with the news and uh global markets, but should they be negative, I have uh no doubt that I'll be having this conversation over the coming months. Uh if you know anybody that's feeling the same way and you feel that this episode could be a good resource, please send it through to people. Give them the reality check, even if it's things they've heard before or a common story that the media is sharing anyway. Just hearing it and having it reinforced is what can help settle nerves and make people feel more comfortable with uh what's going on in the world and their uh how it'll affect their financial arrangements. As per usual, a call out to any listeners that are enjoying the show. I'd love to hear from you. You can get in touch with me on podcast at foxplan.nz. I look forward to uh hearing any feedback, having any questions that you want answered answered on a show, or just generally hearing what you're enjoying about the show. Keep in touch. As for this week, that's us.