Over longer periods of time, index funds tend to outperform actively managed funds in most categories. Recently, total assets in index funds have surpassed the amount of assets in active funds and the gap is now widening. Index funds are more popular than ever. Will investors be rewarded for moving to index funds or could active funds outperform index funds in the future?
Index Funds vs. Active Funds
Actively managed investments can make sense in certain market sectors, but broad market indexes largely outperform actively managed funds. In addition to the difficulty of picking stocks that consistently beat the market, active managers must overcome higher expenses and fees and generating more taxable income from trading. Most active fund managers cannot accomplish these feats consistently over longer periods of time. The headwind to beat the market while charging higher fees is too much to overcome.
Index funds are typically more tax-efficient than active funds because they don’t tend to change very much. The goal of an index fund is to mirror a broad market index, such as the S&P 500, and it doesn’t require much trading or turnover to do that. Active investments, on the other hand, aim to beat market indexes. Attempting to beat the market often involves more trading and investment turnover, which in turn can generate more taxes.
Index funds are also cheaper than actively managed funds, which makes sense. Active managers need to spend more time and energy managing their investments because they are trying to beat the market indexes. Index fund managers need to only mirror their index, which keeps costs down.
The Investment Company Institute studies trends in mutual fund and ETF expenses, and their most recent annual report, released in March, found that index funds still have much lower expense ratios than their actively managed counterparts. The average expense ratio for index equity mutual funds (such as S&P 500 indexes) is 0.05%, and active equity mutual funds sit at 0.64%. That makes actively managed equity funds over 10x more expensive, on average, which is significant over a lifetime of investing. It is worth noting that while actively managed funds are still much more expensive, average active fund fees have dropped significantly over the past 20+ years.
Not only are actively managed funds more expensive and less tax-efficient, but they tend to underperform market indexes. Data from SPIVA finds, time and time again, that passive investments outperform active investments the majority of the time.
In their most recent report, market indexes outperformed over 80% of active funds over the past 15 years in every single category of domestic funds that SPIVA tracks, from small-cap to large-cap to real estate. In some categories, over 90% of actively managed funds were outperformed by their respective benchmarks.
Is it possible that this trend could reverse and more active funds could outperform index funds? Sure, anything is possible. But there are no signs to indicate a reversal in this trend is imminent.
To beat the market, one would have to overcome the tax efficiency and low cost of index funds, in addition to picking an active fund that can consistently outperform its respective benchmark. While beating the market may be difficult, we know there are about 10% to 20% of active funds, depending on the market segment, that outperform their benchmarks. Can you simply invest in active funds that have a history of beating the market and expect continued success?
High-Flying Active Funds
There are certain actively managed funds that have outperformed indexes over long periods of time. Fidelity Contrafund is one such fund. This fund has managed to beat the S&P 500 by about 2% on average, annually, over the past 10 years. This alone is impressive, but even more impressive is the fact Contrafund has returned 13.15% average annually since inception in 1967, besting the S&P 500’s average return of 12.25% over the same period of time. If you invest in an active fund that has a long history of beating the market, can you expect that success to continue?
An analysis conducted a few years ago by a professor of finance at Yale, James Choi, sought to answer this question. Proponents of active funds often believe that past performance of a mutual fund can be indicative of, but does not guarantee, future success. This belief is based in part on a 1997 study that found past performance of actively managed funds does correlate with future success. When Choi extended this analysis to the present day, though, he found that to no longer be the case.
They found that from 1994 to 2018, a fund’s past performance was “completely unpredictive” of future returns. Choi went on to state that, “if anything, over the past two decades, you seem to do a little bit worse if you chase past returns on mutual funds.”
We like to make decisions based on data, and all of the data points towards index funds largely being better investments than active funds. They are less expensive to invest in, have less turnover if you are investing in a taxable account, and beat active funds around 80% to 90% of the time. Even if you do invest in the 10% to 20% of active funds that beat the market, the data tells us that those funds have no better chance of beating the market in the future than any other fund.
It is clear that index investing is one of the best ways to invest for retirement. It also happens to be one of the easiest ways to invest. You can invest in one fund, a target date index fund, and never have to worry about shifting your allocation over time or investing in other funds. Index funds aren’t flashy, but they have a long track record of helping Americans invest for their more beautiful tomorrow.
