Why index funds are often a better bet than active funds

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If you own an investment fund that’s “actively managed,” chances are your returns will lag in 2021. Those odds are even worse over a multi-year period.

Mutual funds and exchange-traded funds are generally “actively” or “passively” managed. In the first case, a fund manager selects stocks and bonds for the fund. This last strategy does not use active security selection, but rather follows an index.

The S&P 500 Index, for example, is a US stock index made up of the largest public companies weighted by market capitalization. An index fund aims to replicate its holdings and returns.

In general, active funds try to beat the market and index funds are the market.

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But active managers did not do well last year. About 80% of all actively managed U.S. equity mutual funds underperformed their benchmark in 2021, the third-worst performance in two decades, according to S&P Dow Jones Indices’ annual SPIVA report.

“It was really exceptionally bad,” said Craig Lazzara, managing director of S&P’s commodities management group.

Some equity sub-categories were worse. About 85% of large-cap US equity funds underperformed the S&P 500, the second-worst percentage on record; the share was 99% for large-cap growth funds relative to their benchmark.

As an investor, your presumption should be that the liabilities will beat the assets.

Craig Lazzara

Managing Director at S&P Dow Jones Indices

However, there were a few exceptions, notably among bond funds. Ten of 14 bond classes beat their benchmarks in 2021, according to the S&P report. (That means more than half of the funds in those categories beat their benchmarks.)

However, the results are not as good over longer periods. According to the S&P report, only four bond categories have outperformed over a 10-year period and none over 15 years.

According to a separate report released last month by Morningstar, only 26% of all actively managed funds beat the returns of their index fund rivals in the decade to December 2021. Foreign equity, real estate and bondholders generally had the highest success rates; success was weakest for large-cap U.S. funds, according to the report.

“As an investor, your presumption should be that the liabilities will beat the assets,” Lazzara said. “And if you make that assumption – for almost anywhere in the world, the asset class and [time] period – you will be justified.”

However, active funds have certain structural advantages over passive funds. For example, because they don’t have to track an index, managers can sell specific holdings that may become too risky.

Many proponents claim that active funds generally shine in volatile markets. Evidence from the Covid-19 market rout suggests otherwise — about half of active funds survived and outperformed their average index rivals in 2020, according to Morningstar.

Costs

The S&P report statistics are averages, which mask wide variations within actively managed stock and bond classes.

Investors who buy an actively managed fund can improve their chances of picking a winner by buying a lower-cost option.

Underperformance tends to be correlated with higher costs, according to Ben Johnson, director of global ETF research for Morningstar. (In other words, lower cost funds had a higher chance of success.)

Cheaper active funds outperformed about twice as often as more expensive ones (35% vs. 18%) in the decade to Dec. 31, 2021, Morningstar found.

“Fees are significant,” Johnson said. “They are one of the only reliable predictors of success.”

Fees are a big reason why index funds typically outperform their actively managed counterparts. The average asset-weighted fee for an index fund was 0.12% in 2020 compared to 0.62% for active funds, according to Morningstar. (These are annual fees that represent a percentage of an investor’s total fund assets.)

This means that the average active fund must earn an additional 0.5% to match the performance of the average index fund.

According to Jeremy Siegel, professor of finance at the Wharton School at the University of Pennsylvania, an active manager needs to have 10 years of above-market performance to make a compelling case for skill over luck.