It's More About Costs Than Being Active or Passive

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription here. 

In the age-old active-versus-passive debate, it's funny how little is written about how index funds and actively managed funds have actually performed.

I've run a few studies that suggest that good performance is not about active versus passive. It's about low costs versus high. And by the way, low costs are not necessarily a vote for passive investments.

I set out to test how each group has performed during the past 10 years in a study that was not biased by survivorship. The past decade has seen huge numbers of funds killed off, so to ignore that segment would be a big mistake.

My chief test here was success ratio. The success ratio tells you what percent of a group survived and outperformed its peers. I started with the universe of funds that were in existence as of Jan. 1, 2001. Then, I divided that universe into active and index groups. I included all share classes in my tests.

There were 542 index funds at the beginning of the period. Of those, 133 were still standing 10 years later and had outperformed their peers, producing a 25% success ratio. Another 246 of them, or 45%, survived but underperformed. Finally, 163, or 30%, of the original index funds were liquidated or merged away during that time period.

There were 15,789 actively managed funds, including all share classes, to start the period. Of those, 3,855 outperformed during the next 10 years, producing a success ratio of 24%. Thus, the actively managed funds had roughly the same success ratio as the index funds. A total of 4,186 of the actively managed funds, or 27%, survived but underperformed. Another 7,748 of them, or 49%, were killed off. Here we see a dramatic difference between active and passive funds. Nearly half of the actively managed funds were killed off, whereas 30% of index funds didn't survive the ensuing 10 years.

One reason for this may be that active funds are more likely to dramatically underperform. Also, people tend not to blame a fund company if an index fund underperforms its peers as long as it closely tracks its benchmark. Thus, fund companies may have less desire to sweep index laggards under the rug.