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Index Versus Active: What the Data Say

Focusing on low expenses helps investors succeed, regardless of whether they take the active or passive route.

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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, a vote for low costs is not necessarily a vote for passive investing.

To take a fresh look at how index and active funds have performed, we grouped active and passive funds together within each asset class and then examined their success ratios five years later for the period ended Dec. 31, 2010. The success ratio tells you the number of funds that survived and outperformed the category average over the ensuing periods. By looking at it that way, you can eliminate survivorship bias and allow comparisons across low-return and high-return categories.

Overall, passive funds did a little better than active. Among domestic-stock funds, index funds produced a success ratio of 39%, versus 34% for active. Inter­national funds were the one win for active funds, as their success ratio was 33% versus 18% for index funds. A likely cause is that EAFE index funds had a low emerging-markets weighting compared with active funds in the foreign large-blend category.

Balanced funds were the most impressive win for index funds. Index funds produced a 62% success ratio there, versus 32% for active funds. The asset class doesn’t have a lot of index funds (just 52 at the beginning), but those that were there did well.

Among taxable bond funds, index funds produced a 56% success ratio compared with 42% for active. No doubt, the 2008 meltdown of everything that didn’t have a govern­ment guarantee hurt active funds, as nearly all actively managed intermediate-bond funds had more than Barclays Aggregate’s weighting outside govern­ment debt. However, active funds rebounded nicely in 2009. There are no municipal-bond index funds, so we’ll skip that one.

Index Versus 5-Star Funds
So, would you have been better off picking any index fund or any 5-star fund five years ago? In each case, funds with Morningstar Ratings of 5 stars produced a higher success ratio. In the domestic stock group, it was 51% to 39%. In foreign stocks, it was 52% to 18%. For balanced funds, the star rating won 69% to 62%. For taxable bonds, 5-star funds had a success ratio of 63% versus 56%.

You Can Use More Than One Data Point
My conclusion here is the same as that from the report on stars and expenses: Buying based on a single data point is a bad idea, but putting together a few telling data points gets you to a very strong list.

The less-articulate advocates of indexing often make their case by assuming that index-fund investors get the index’s return and active fund investors pay the average active-fund expense ratio. That would mean index-fund investors are so savvy that they miracu­lously pay less than the cheapest index fund out there and that active investors are so dopey that they don’t make the slightest attempt to find low expenses. The case for indexing is solid without these distortions.

If you look for low-cost funds with strong records you’ll probably do quite well, whether you opt for active or passive funds. We have both types among our Fund Analyst Picks, and there’s certainly room for both in most investors’ portfolios (mine included).

Indexing tends to have lower costs than does active management, but in both cases you still have to be a savvy investor and look for low costs. Consider two large-blend funds: the 4-star  Vanguard Total Stock Market Index (VTSAX)  charges 0.06% and the 5-star  Vanguard Dividend Growth (VDIGX)  charges 0.34%. At the latter, Wellington’s Donald Kilbride only needs to make up 28 basis points per year to match the returns of the former. I think he’s got a pretty good chance, so the case for both funds is strong.

A version of this article appeared in Morningstar FundInvestor.

Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.