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Vanguard's Davis makes case for index funds even in tough times

BOSTON, Nov 22 (Reuters) - The rush of money into big index funds has raised concerns about whether they would still prove attractive in a downturn, an issue taking on more importance especially for industry leader Vanguard Group Inc as its passive products soar in scale.

A common view is that while passive funds would face loses in declining markets, active managers could be better prepared because of factors like cash holdings or farsighted stock selection. Greg Davis, named chief investment officer of Vanguard in July, acknowledged some active funds would fare better. But many active managers, especially in bond funds, have taken on more risk to boost returns and make up for their higher costs, thus setting themselves up for problems, he said.

"You could actually see them underperform by even more than what you would expect," Davis said.

Davis spoke with Reuters just after the company held a rare shareholder meeting for fund investors in Scottsdale, Arizona last week.

For the 12 months ended Sept. 30 its passive funds took in $335 billion, easily beating rivals, according to Morningstar. Another $6.4 billion went into Vanguard's own active funds, and its total assets are approaching $5 trillion, the most of any mutual fund firm.

Helping Vanguard and other passive fund managers has been the fact that 88 percent of large-cap active managers underperformed their benchmarks over the five years ending Dec. 31, 2016, according to S&P Dow Jones Indices. Mid-cap and small-cap managers fared even worse.

Passive fund performance generally tracks market indexes. At times both fund types decline in value: In 2008 when the S&P index fell over 38 percent in its worst year ever, actively managed large-cap equity funds on average fell by 38.35 percent, according to Morningstar. Index funds fared little better that year, falling 37.67 percent.

Active proponents still make a case for stock-picking. Benchmarks used by passive funds can overweight risky holdings, favoring active managers in down markets, wrote Morgan Stanley Wealth Management's head of investment and portfolio strategies Lisa Shalett in a paper earlier this year. Faster growth or more volatility could also help.

"Active managers may soon have an edge," she wrote.

Morningstar found 49 percent of active U.S. stock funds beat their benchmark for the 12 months ended June 30, up from 26 percent for the 12 months ended Dec. 31.

Ben Johnson, a Morningstar research director, said the uptick reflects active managers benefiting from factors like buying high-performing stocks outside their benchmarks, gaining from what he called "stylistic messiness."

But some active funds have taken on more risk along the way, Johnson said, echoing points made by Vanguard's Davis. While about 85 percent of intermediate-term bond funds outperformed for the 12 months ended June 30, Johnson said many did so by holding sub-investment grade credit not present in some index funds. That debt that could be hard to sell in tough times.

It could be a while before an actual economic downturn guides the debate. Davis said it is hard to predict when U.S. economic growth might end and said, "We don't see any catalysts that would cause a recession in the next 12 to 18 months." (Reporting by Ross Kerber; Editing by Carmel Crimmins and Lisa Shumaker)