Ask where one should invest a modest amount of money and nowadays the answer will most likely be to put it into passively managed index funds. It’s a very compelling and simple financial strategy:

1. Buy one or a combination of low cost index funds, preferably a mix that gives you exposure to a mix of bonds, domestic and international stocks.
2. Continue buying every now and then.
3. Wait and let the market do its compounding returns magic.

And it’s been really hard to beat, with legendary investor Warren Buffet even winning a famous bet on the performance of passive vs. actively managed funds: https://www.investopedia.com/articles/investing/030916/buffetts-bet-hedge-funds-year-eight-brka-brkb.asp

Passive investing is simple, cost-effective and accessible to anyone.

As a fund receives capital inflows, the fund purchases assets. Many popular funds are designed to track the general performance of an index. For example, the SPY SPDR S&P 500 ETF Trust seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500 Index by holding a portfolio of the common stocks that are included in the index. Pretty neat!
As a fund experiences capital outflows, at some point the fund will likely need to sell some of its assets.

Let’s now imagine a market crash scenario. Market crashes are relatively rare events, but they happen once in a while. The economy is slowing, people are spending less and hiring has slowed down. Many investors and institutions start selling and few are buying. One day prices tick downward to double digits and some panic ensues.

How would index funds react? Well, they wouldn’t, not right away. Over time the value of a fund would drop, causing some investors to sell the fund and forcing the fund to liquidate some of its assets due to redemptions. A bank run on a fund would hasten the liquidation process, but this seems an unlikely scenario (< 5%). I would imagine most passive funds are held with a long term strategy of buy and hold.

I would imagine two different outcomes, for two different scenarios:

A) The minor crash scenario (a <30% market drop that lasts less than 6 months)
Passive funds act as “dampeners”; by holding assets more firmly, they avoid creating short term fire sales.

B) A major crash scenario (a >30% drop that lasts more than 6 months)
Passive funds act as “amplifiers”; investors are forced to sell some of the funds and the funds, needing to liquidate their assets, start dumping indiscriminately, regardless of company fundamentals. This will affect small or illiquid assets the most.

While passive funds should outperform (lose less) an average buy-and-hold portfolio even during a crash in either scenario, due to their steadiness and lack of impulsiveness, I however wage that in the aftermath of a scenario B (and to a lesser extent, that of A), such funds should for 5-10 years under-perform a carefully picked portfolio of profitable companies (if any are left), because passive funds would not be able to pick bargains based on fundamentals. While the market figures out which direction it’s going, the returns on these funds might be less than what people have been blessed with so far in the past 16 years.