Although I mention other methods of investing around here from time-to-time, the fact is that most of my retirement investments remain ensconced in index funds. Index funds are mutual funds created to track the movement of a stock market index, such as the NASDAQ or the S&P 500. Their goal is to earn the same return as their corresponding index.
But in a year like 2008, during which the stock market fell about 40%, who wants average? Well, I do for one. Because index funds are “passively managed”, they have very low fees, so that their average returns produce above-average results when compared to other investment options.
In a recent New York Times article, Mark Hulbert describes a new study that shows “index funds win again”. According to research from Mark Kritzman of M.I.T.’s Sloan School of Management, actively managed mutual funds and hedge funds need ongoing outsized gains in order to beat indexing. From Hulbert’s article:
Mr. Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.
The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.
In other words, based on past results, you have only a 3% chance of choosing an actively-managed mutual fund that will beat the average index fund over the the long term. The article concludes that it makes little sense for the average investor to justify active management of her portfolio if her goal is to grow wealth.
[The New York Times: The index funds win again, via Joel P.]
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Great to know! Thanks for posting this. My invested money is entirely in index funds and I always wonder if I’m doing the right thing.
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Beth: remember, the right thing depends on you, your risk tolerance, and your goals. For me, the right thing is to continue with index funds. And articles like this simply reinforce my decision. But this isn’t the right choice for everyone.
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I remember reading that article and thinking I had some questions/reservations about what they were considering an actively-managed fund “average” fees. To be sure, there are a lot of actively managed funds that have enormous fees (especially loaded funds, ugh), but the “average” fee that they touted was WAAAY higher than some of the funds I have in my portfolio. Maybe it’s because I just go with funds through discount brokerages like Fidelity and Vanguard?
I definitely love index funds, and think they are a fabulous choice for a lot of people, but actively managed funds seem to sometimes get more of a bad rap than they deserve in these articles. The actively managed world is very large indeed to talk about using sweeping generalizations.
Additionally, it’s worth noting as well that picking the funds you’re going to use and analyzing their fee structure and prospectus is only half the battle. Asset allocation is in my estimation even more important than the question of active vs index management.
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I think 3% is still too high- 20 years isn’t that long for a retirement investment. If you started investing at 30 and lived to 90 you could hold an investment for 60 years!
-Rick francis
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Awesome summation, JD! It always amazes me that more people don’t understand the benifits of Index Funds!
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So should the smart investor’s 401(k) be a straight mix of index funds and bonds, with no actively managed funds?
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Yep, I took Warren Buffett’s advice (on what a young person should do with his first million last summer) to invest everything in an index fund that tracks the S&P 500 and get back to work. Luckily I’ve only lost 53%. It would have really hurt to have lost 57%
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@mathew (#6)
It totally depends on the investor. This is a call that you have to make based on your situation. There’s no one right answer. I know that sounds like a cop-out, but it’s the truth.
For myself, close to 40, I have a few thousand dollars in individual stocks (which are WAY down), and the rest of my savings is split between two buckets: the first bucket is FFNOX, a Fidelity fund that has bonds, domestic stocks, and foreign stocks; the second bucket is a group of Vanguard index funds.
This is what works for me and my situation. If I had a million dollars, I’d have the money in much lower risk investments. Why? Because I’d be more interested in capital preservation than capital appreciation. That is, I’d want to protect the money I had rather than grow it. Does that make sense?
For me, it makes sense to put the “equity portion” of my portfolio into index funds. I think it makes sense for most people. But it doesn’t make sense for everyone…
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Question: why do you prefer Index Funds rather than Exchange Traded Funds? As far as I can tell they are essentially the same thing except that ETFs are traded like stocks where as Index Funds are set up more like mutual funds. (Please correct me if I’m wrong.)
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It’s odd that people complain about fund fees and other such minutiae after losing almost half of their portfolio value because they followed the flawed strategy of “buy and hold.”
Actively managing your OWN portfolio and taking responsibility for your losses and gains is the best approach. Many people (not on Wall Street) saw this downturn coming and switched into cash before the crash. It wasn’t hard, and it wasn’t magic, but it did require some research and preparation.
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While index funds outperform managed funds, it is still investing in what you do not know and can’t control. I think they are both poor choices.
Wise investors know what they are buying. And they can control the investment.
Their own business, cars, houses, antiques, individual companies (not markets), collectibles, furthering their education, etc.
#1 rule. Always invest in what you know and can control. Otherwise you are just along for the ride.
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I have gradually switched a lot of my investment to index funds and ETFs since last year.
I was motivated after Warren Buffett made a bet with a hedge fund to compare returns against an index fund.
Index funds represent the collective behavior of the market itself. It may be boring as you don’t outperform the market but you don’t suffer drastic losses too.
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The title of the article is misleading, and would suggest that index funds outperform actively managed mutual funds in general. However, the only index fund data presented is S&P 500. In reality there are thousands of different indexes across the global stock markets, and that is just one specific index index which was chosen. You say only 3% of mutual funds outperformed S&P 500. So I ask, what percentage of index funds outperformed mutual funds?
If you chose Nikkei 225 as your benchmark index fund (which is one of the top three or four biggest and most watched stock indexes on the planet), you would find that it greatly underperformed actively managed funds over the past 20 years. (It just hit 26 year low.) So a just as valid article would be “The Index Fund Loses Again” if you look at just that index.
In reality, index fund investing is not much different from individual stock picking. There is nothing magical about index funds. If you choose an index which ends up being a loser, it is no different than buying stocks which are losers. And the safer you go by diversifying more (e.g. buying total world stock market index funds) the lower your returns will be.
So a better title would be “One specific Index Fund, the S&P 500, Wins Again”, until data is collected and presented showing that the thousands of index funds currently on the market outperform actively managed funds.
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Troy – Interesting perspective. I agree that you should invest in what you know, but I also disagree in a way.
Sure, for the tangible goods you listed, you should know something about them before investing. But for me there is a big trade-off required to know enough to invest in individual companies.
The time and effort I would need to expend to evaluate an individual company just is not worth it. Besides, when you invest in individual companies, you are exposing yourself to two types of risk (company-specific risk and market risk).
I am more than happy to invest in an index in order to completely eliminate company-specific risk.
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“This study sponsored by Vanguard”
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“This study sponsored by Vanguard”
And who owns Vanguard? Oh, it’s owned by its funds and investors as a de facto cooperative. Never mind.
Nice comment-fail by Mac … but thanks for coming out.
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As much as I love index funds, it may be worth mentioning that the study included taxes as an expense, so the numbers may not be accurate for someone investing through a tax-deferred vehicle.
I don’t trust myself to pick actively traded funds, but the article itself said that if you’re investing in a 401K or IRA, “the odds are relatively more favorable for active management, because, in his simulations, taxes accounted for about two-thirds of the expenses of the actively managed mutual fund and nearly half of the hedge fund’s”
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If the only choices were actively managed funds or index funds I would agree go with the index fund. The probalem I have with index funds is that in buying these funds you are buying every poorly managed, fradulent buggy whip maker out there.
You can purchase a small basket of stocks that effectively track indexes without the risk, at a discount broker the fees are low and you are in control. A little research will weed out the worst fo the frauds. This has worked well for me I’ve been beeting the averages for years now, it is not rocket science I spend perhaps a couple of hours a month reasearching and trade just a few times per year. One exception is I have an index fund for small cap compamies, individual small companies are too risky and it is difficult to buy enouoh of them to smooth the risk out.
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A collection of index funds is a great low cost way to beat the market. If you owned 50% Vanguards Index 500 (-38% LY) and 50% Vanguards Total Bond Index fund (+5% LY)you’d be down 16.5% last year. Not great, but not catastrophic. Take a look at marketwatch.com/lazyportfolio for other ideas. I agree with adjusting your mix to reflect economic conditions. I had been 60% stocks/40% bonds, moved to 1/3 stocks, 1/3 bonds, 1/3 cash the week before the election.
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I would have thought my index ETFs were fabulous…had I not purchased a huge amount the day before the market started to slide in September.
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Just add another argument to the pile of pros for index funds…
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I’d have thought the main drawback to managing your own money directly as Alex (#10) suggests, is that it is extremely timeconsuming. You are betting that you, with little time to devote, can do better than either a sensible asset allocation in index funds or actively managed fund (whose managers work full-time for lots of money). Besides which the more you move cash around, the greater the cost as a rule.
Alex might be extremely skilled at this, but I know I am not. Therefore, for me, index funds are the best solution. Easy and guaranteed approximate average is better for me than hard, time-consuming and onle a calculated bet at getting higher than average returns.
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Plus, you get economy of scale by investing in index funds. It is extremely hard for your average investor to replicate an index cost efficiently. The cost and time just isn’t worth it. I like the lazy man’s portfolio, while working rebalance with new cash, otherwise rebalance every 5 years or so. I also really like Troy’s point #11.. FIRST should be an investment in your education and income producing ability. That is where you will get the most bang for your buck, investments are secondary.
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This post and the argument center on a small specific portion of the picture. Mutual fund investing.
My point above is to take a step back and look at the whole picture. That is the point of the argument.
There are millions of places to put your money. Mutual funds are one.
That still leaves about a million other places to “invest”
You can “invest” in many things besides mutual funds, or stocks, or the market.
Index investing is the best type of mutual fund investing, but it is flawed. There is no control. It is investing in the “market”
Successfule investors don’t invest in the market, they buy companies. The wealthy became that way buy buying companies, or starting them. The market had nothing to do with it.
So my point isn’t whether indexing is better. It is. but it is only better than the other poor choices regarding market participation.
Instead, look at other options. They can be whatever. Education for a better career. Talk about a return on investment. Fixing real estate, vehicles, and all the other things I mentioned.
There is alot more to investing and financial security than mutual funds.
When you put your money into something you know, and something you can control, you will be better off because you can actually do something about it.
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Okay, first off let me say that I really like index funds. They are very cheap and you won’t “lose” in the end.
That having been said, there are many assumptions that are simply not true in this article in the NY Times. Namely, that the average expense ratio of a managed mutual fund is 3.5%, and a hedge fund’s is 9%! Maybe, if you are using only funds that carry sales loads, could that be true, but the industry average I have heard is more in the ballpark of 1.5%, not 3.5%.
Also, when a mutual fund reports performance, it is required by the SEC that those performance numbers are net of all fees. So when you look at which funds beat the index on Morningstar’s records, they don’t need to beat it by 4.3%, they just need to beat it, period. Granted, taxes still play a part in the equation, but taxes are not going to make the difference of 4.3%.
Maybe I’m reading all of this wrong. Again, I am a big fan of index funds. I just think the author of that article should use correct facts when reporting.
And you should also compare different asset classes. It is much harder to outperform a US Large Cap index, since it is covering huge companies that analysts know everything about. But what about an Emerging Markets fund? If you have a good manager, I think it is possible to beat the EM index on a regular (not every year, but regularly) basis, after all fees. Just my 2 cents.
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Sure, index funds make a ton of sense with something like the S&P500. Even Vanguard admits that managed funds do better when you start getting into things like small cap value funds though. They put out an article a while back about it.
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If you read the full article there is a MAJOR detail:
“in his simulations, taxes accounted for about two-thirds of the expenses of the actively managed mutual fund”
So MOST of the difference is due to tax advantage of index funds.
He says the expenses are 3.5% for mutual funds. 2/3 of that for taxes is 2.3%.
After expenses he says index performance was 8.5% and active managed funds was 8%. If the investment is tax sheltered, then I’d expect you’d have 2.3% better performance for the mutual fund which would put it 1.8% better than the passive index funds.
He’s also assuming maximum tax rate of 42% (fed + state) which is NOT typical. Most tax filers are in the 15% federal bracket or lower. Average taxes marginal paid are probably more like 20% total for fed + state. But on the other hand typical stock investors are probably more likely to be in higher tax brackets.
Jim
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For a non-scientific study demonstrating the the “Proof of Index Fund Superiority” see my post on JustforFunds. Over the last 10-year period, Vanguard index funds beat their category averages either before fees and taxes, after fees and taxes, or after 15 years before taxes, depending on the category.
Here’s the link: http://justforfunds.blogspot.com/2009/01/proof-of-index-fund-superiority.html
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I’m thinking of going self-directed very soon on my own retirement fund, so Index Funds seem like a great option.
My only concern is when the market goes down, so do your funds.
I think I might prefer to take a more active approach to investing, though.
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It’s simple common sense. How could active managers on aggregate beat the market? The market is made up of all of these active managers trading with each other. For one to outperform, another needs to underperform, so on aggregate their performance will match the market index less their fees.
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I feel like I showed up and the party’s all ready over. (Sigh.) Oh well. Here’s my two bits:
No one has a when an actively managed fund goes up (or sideways) when the market is goes down. But what do you do when when the market and a fund’s peers are going up (or sideways) and the fund itself is going down? It is tricky and time consuming to determine why or to determine if you’ve picked a loser versus one that will pay off in the end if you hold tight. When my money is in an index fund, since it IS the market, it simplifies my decision making if I choose to more directly manage it, i.e. is the market overvalued, am I taking on too much risk in my given asset allocation, etc.?
Also it’s the fund’s expense ratio, taxation AND transaction costs due to turnover (trading) that put a significant drag on active funds, which is probably why the need to outperform indexes is as high as 4.3% on average. Transaction costs are not revealed in a prospectus or fund stats. Many funds, if not most, have an average annual turnover of 100% (read: lots of hidden costs); some have it way higher. The “buy and hold” of index fund investing isn’t just about a consumer buying and holding through thick and thin to reduce his or her own timing, tax and cost risks, it is that the fund itself also buys and holds which makes turnover minimal–greatly reducing fund transaction costs and reducing taxation (each of which don’t show up in fund fees/expense ratios).
Even if you have a Roth IRA, the fund itself, doesn’t benefit from the IRA. The fund is still taxed on capital gains, etc. before being able to add to your returns, even if you will not ALSO be taxed when you withdraw. That aspect of active fund management drags down your return, especially if your fund trades a lot.
An index fund’s costs and tax liabilities increase when fundholders panic and a major selloff ensues. If deposits are less than withdrawls, the fund must sell stock to pay out. However, this detail is no worse than in actively-managed funds, where the same selloffs were going on in 2008-2009.
If I understand ETFs (I have none) an ETF can avoid a tax impact because it may be a able to hold assets during a selloff and simply sell a panicker’s share to someone like me who thinks it is probably less risky to buy at such times. The only tax consequence in that scenario is to the individual investor who sold the ETF share at a gain or loss, not the ETF fund itself, and not those who kept their heads and held the ETF through it all.
A funds fees, taxes and costs–lumped with the individual’s personal taxes and costs could be the most important determinants of investment performance. Now if only we, as investors, could reap the benefit of the fund’s performance by not buying in when those active funds are bloated, or after the best (if not only) gains are behind them–a.k.a performance chasing–we might benefit as well. An indexer does not worry about asset bloat. It’s not worry free investing, mind you; it’s just a little less to worry about.
401(k)-ers, etc. who ignored the market and were foolish enough to not only to hold onto their broad stock investments, but to continue buying, have seen that they’re not doing too shabby. Dollar-cost averaging is still working for them, since buying low could boost future returns significantly (the market IS up 60% since it’s march low). Not only did I do that myself, but I put as much new money into stocks as I could. That new money has seen a remarkable return to reward my risk-taking. To me, with my few assets, it seemed less like risk-taking and more like opportunitism. ;o)
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