Index Funds vs. Actively Managed Funds: Which Is Better?

Oct. 20, 2009 — -- In the world of investing, there's one argument that's likely never to end.

That's the fight over index investing versus active management.

Are individual investors better off putting their money in low-cost, passively managed index fund designed to match the performance of particular market segments?

Or should they chase the potential for market-beating performance promoted -- but seldom achieved -- by actively managed funds?

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No matter what the evidence shows, I suspect this argument will continue forever. It's just human nature.

I sit squarely in the pro-index camp, but I try to keep an open mind and under limited circumstances will entertain a modest investment in an actively managed mutual fund.

The latest evidence, however, tells me I won't be changing camps anytime soon. In my view, the vast majority of individual investors are better off investing in a mutual fund or exchange-traded fund that tracks an index like the Standard & Poor's 500 rather than one that tries to beat the index.

The simple reason is that your chances of picking an actively managed fund that can beat its benchmark index for more than a couple years in a row are mighty slim. Yes, you might get lucky and latch on to a hot fund for a few years, but you are much more likely to pay too much for a fund that underperforms its particular segment of the stock or bond markets.

I'd rather concentrate on easily avoided underperformance and forget about a futile chase for market-beating performance.

The latest study to fuel the index-versus-active debate comes from Morningstar, the Chicago-based research firm that caters to individual investors.