A New Take on the Indexing Versus Actively Managed Funds Debate
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It's another win for index funds.
If you're a regular Money reader you'll know the mutual fund world has been split by a long-running debate between two fundamentally different investment strategies: Active investing, where funds employ portfolio managers to attempt to select stocks that beat the market benchmarks like the Standard & Poor's 500, and indexing, where funds aim merely to match the performance of the benchmarks.
While it may be counter-intuitive, academic research has shown that because of a) the inherent difficulty of consistently picking stocks that outperform the market averages and b) the extra costs incurred by these funds for things like research, brokerage fees, and manager salaries, only the most skillful stock pickers actually end up beating the benchmarks over long periods of time. Plus, determining who those managers are in advance is a fool's game.
Not surprisingly, given the livelihoods at stake, this is a controversial conclusion. Now fund researcher Morningstar has offered up a new approach to the debate. While index funds are known for keeping investment fees as low as possible, costs can put a drag on their returns, too. So Morningstar set out to compare active funds not just to the returns of market indexes, but to the actual index funds that attempt to track them. The method could arguably yield a fairer comparison, more in line with what investors actually experience.
Unfortunately for the partisans of active management, the results were as clear-cut as those of any previous study, if not more so. Among the twelve types of funds Morningstar examined—from large blend stock funds to intermediate bond funds—the majority of active funds beat their passive counterparts in just one category over the past decade: U.S. mid-cap value.
Morningstar did find that investors could improve their odds by focusing on active funds that had lower costs. The majority of low-cost active funds, those in the least expensive quartile of their peers, beat low cost index funds in five of twelve categories, including U.S. large and mid-cap value funds.
Of course, since cost is still the key factor, that's likely to be cold comfort to many active investors.