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.]