Index Funds vs. Actively Managed Funds: Which Is Better?
Why actively managed funds may not be worth the risk.
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?
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.
Last week, Morningstar released a study that shows just 37 percent of actively managed U.S. stock mutual funds beat their respective Morningstar indexes after accounting for risk, size and fund style.
The Morningstar study is unique in that it went beyond overall fund performance and adjusted for other factors, including the level of risk taken on by active managers in their effort to outperform the market.
For overall performance, the Morningstar report concluded that about half of all U.S. active stock funds beat their respective Morningstar indexes over the last five years, but when risk level was considered, these funds did not hold up nearly as well.
Results from the past three years suggest "that performance has not been enough to account for the increase in risk taken on compared with the Morningstar indexes,'' the report says.
In essence, that means if an investor wants a fund that beats its benchmark index, he or she has to be willing to tolerate greater risk taking by the fund manager.
That sounds fine in years when the stock market is up. But over the past year, many investors found their tolerance for risk was not as great as they thought. In theory, an investor might be willing to accept the risk of a 40-percent portfolio decline, but the reality of living through that as we did recently is a lot different. That's why many small investors fled stocks over the past year and missed out on the rally we've experienced since March.
Morningstar intends to publish its comparison of active funds to index performance every six months so if you remain unconvinced about the merits of index funds over actively managed ones, you can check back early next year. This new twice-a-year report is called the Morningstar Box Score Report.
It's important to note that in this report Morningstar looked at only U.S. stock funds. It did not include international stock funds or bond funds of any kind.
Standard & Poor's did take a look at bond funds in its own comparison of index and actively managed mutual funds released in late summer. It found that more than three-fourths of active managers failed to beat their fixed income benchmarks and called the results "unequivocal."
But the Standard & Poor's report concluded domestic and international stock funds "performed in line or marginally ahead of benchmarks" over the previous 12 months.
So there was a glimmer of light for the active-management crowd, offering yet one more reason I think this is one argument that will never end.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.