How To Reduce Your Downside Risk

The addition of indexing to a portfolio of actively managed investments may markedly reduce an investor's downside risk. 

A recent Vanguard research paper looks at the possible impact on downside risk if a selection of actively managed equity funds had instead half of their portfolios indexed. Investment strategists ranked the performance of all US diversified equity funds in the five years to December 2011 and then tracked how the 1,109 top quintile funds performed over the subsequent five years to December 2016.

Of these once top performers, almost 37 per cent were "significant" underperformers over the second five year period. (Significant underperformance was defined as annual returns of two per cent or more under than their own benchmarks.) But what would the impact have been on performance of those once top quintile funds in the second five years if half of their portfolios had been indexed to benchmarks matching their investment styles?

The researchers effectively created 1,109 'new' funds – half index, half active – to answer this question. By adding this degree of indexing, the percentage of significant underperformers was cut to under 15 per cent – down from almost 37 per cent.

The key message for investors is that adding index funds or index-tracking exchange traded funds (ETFs) can markedly reduce their overall downside risk of their overall portfolios, depending on the extent of indexing - the larger the indexed proportion of a portfolio, the greater the reduction of downside risk.

Many investors, for instance, choose to have the core of their diversified portfolios in index funds and hold satellites of actively-managed funds and other active investments.

Further reading: The case for active/passive portfolios, Smart Investing, March 5.