Passive funds have long been touted by their you-can't-beat-the-market proponents. But lately the clamor for index funds has grown louder and less rational. Don Phillips, Morningstar's president of fund research, worries that a “lunatic fringe” is influencing attitudes about indexing. MarketRiders, an online service that helps design ETF portfolios, recently compared actively managed funds to tobacco manufacturers. In an e-mail quoted in The New York Times, the company said that a portfolio of actively managed funds is “as bad for your wealth as smoking is for your health.” In a recent book, David Swensen, the respected chief investment officer of the Yale Endowment Fund, makes the case for index funds and says that the high fees of actively managed funds amount to “thievery.”

To be sure, low-cost index funds can be sensible choices. But it is not clear that active funds are always bad and passive portfolios will necessarily come out ahead. To appreciate how passive investing has actually performed, consider some recent research by Morningstar. According to the study, there were 542 index funds in January 2001. During the next 10 years, only 25 percent of the funds surpassed their category averages. Of the rest, 30 percent went out of business and the others trailed the averages. Index funds that finished in the bottom half of their categories during the last decade include Schwab Small Cap Index (SWSSX), T. Rowe Price Equity Index 500 (PREIX), Vanguard Extended Market Index (VEXMX), and Dreyfus International Stock Index (DIISX).

Excessive Faith?

Have all those index funds failed? By the standards of the bloggers, index funds that finish in the bottom half have missed the mark. Of course, more thoughtful investors should recognize that most index funds have been accomplishing what they are designed to do. Because they track benchmarks, index funds almost never hit home runs or strike out. Instead, they tend to finish in the second or third quartile of the performance standings. That kind of steady vehicle is an appropriate choice for many investors.

On average, active funds do about as well as index funds. Of the active funds that existed in 2001, one quarter survived for the next decade and outdid their categories, about the same percentage as the index winners. But there is a crucial difference between active and passive funds: the results of active funds tend to be more scattered, with some managers finishing in every quartile — including the top and bottom. Considering this data, it is clear that index funds may be the best choice for investors who want to avoid finishing in the bottom quartile. Active funds make sense for investors who aim to customize their portfolios and possibly outperform.

Much of the excessive faith in index funds rests on flawed interpretations of research. Widely quoted studies often say that most actively managed funds trail benchmarks, such as the S&P 500. The studies are correct. But the active funds fail to outdo the benchmarks entirely because of expense ratios. It is not surprising that the active funds lag because the S&P 500 is a theoretical benchmark with no expenses. To actually track the benchmark in the real world, you must hold an index fund, and those come with expense ratios. Like active funds, index funds generally lag the benchmarks by amounts that are about equal to their expense ratios.

Bloggers and others such as Burton Malkiel and John Bogle say that index funds are better buys because of their low expenses. And it's true that index funds with tiny fees of less than 0.15 percent are worth considering. But not all index funds qualify as the cheapest choices in their categories. The average index fund has an expense ratio of 0.62 percent, according to Morningstar. Many top active funds have expense ratios that are close to the index average. In some cases, active funds have lower fees than competing index funds.

Vanguard Health Care (VGHCX), an active fund, has an expense ratio of 0.36 percent, while iShares Dow Jones US Healthcare ETF (IYH) — which tracks an index — charges 0.48 percent. Elfun International Equity (EGLBX), an active fund, charges 0.27 percent, while Vanguard Total International Stock Index (VGTSX) charges 0.32 percent. “You can do well with either index or active funds, but it is important to stick with low-cost funds,” says Russel Kinnel, Morningstar's director of fund research.

Since the market downturn of 2008, more investors have been persuaded by the arguments in favor of index funds. During the 12 months ending in January, investors pulled $80 billion out of active domestic equity funds and poured $18 billion into passive funds. Some of those investors are abandoning active funds for irrational reasons, argues Kinnel.

Consider that the S&P 500 lost 37 percent in 2008, and active funds performed about in line with index funds. Investors had good reason to be disappointed with funds of all kinds, but much of the ire focused on active portfolio managers — and the financial advisors who recommended them. Angry investors said that the active managers should have shifted to cash well before the damage occurred. But the notion that managers should be able to time the market perfectly is absurd, says Kinnel. Under SEC rules, most managers cannot suddenly move to cash. The rules state that funds must be true to their names. So if a fund has the term “mid-cap” in its name, the portfolio must have 80 percent of the assets in the asset class. Such stock-heavy funds are bound to lose money in downturns.

Just as the exodus from active funds was partly motivated by irrational considerations, investors also made questionable moves with bond funds. While active stock funds about matched the benchmarks in the downturn, active bond funds trailed badly. In 2008, the Barclays Capital Aggregate Bond Index gained 5.2 percent, and the average intermediate-term bond fund lost 3.7 percent. Even PIMCO Total Return (PTTAX), which is run by bond star Bill Gross, trailed the benchmark by 0.9 percent. The gap occurred because most active funds have big holdings of corporate bonds, which crashed in the fall of 2008. The benchmark mostly holds government bonds that soared during the turmoil.

Based on the attitude of investors toward active stock funds, you would think that angry shareholders should have dumped active bond portfolios and shifted to index funds like Vanguard Total Bond Market Index (VBMFX), which returned 5.1 percent in 2008. But investors treated Gross and other active bond managers like heroes because they made money in a year when stocks suffered huge losses. For much of the past two years, shareholders have been dumping active stock funds and pouring the cash into the PIMCO fund and other active bond portfolios.

The investors who dumped active stock funds had terrible timing. Since markets hit bottom in March 2009, many active stock funds have been soaring, outpacing stock and bond index funds. Instead of panicking and dumping solid investments, shareholders should have been following a sensible policy of buying low-cost funds and holding them for years.

An Alternative

Will the shift away from active stock funds continue? Perhaps, but not all active funds are losing the race. Since the market downturn, cash has been flowing into alternative funds (see related article on page 86), including long-short portfolios and funds that aim to deliver absolute returns, says Loren Fox, senior research analyst for fund tracker Strategic Insight. The alternative portfolios are attracting money because they avoided big losses in the downturn, and many of the funds can help to diversify portfolios in rocky times. Investors are moving to the alternative funds, even though they charge high fees. According to Morningstar, the average long-short fund has an expense ratio of 2.07 percent.

Fox predicts that future demand will grow for two kinds of funds. First, more investors will seek index funds and other portfolios that can deliver market returns at low costs. In addition, shareholders will gravitate to very active funds — including alternative strategies — that promise to offer something extra. “The investing public is becoming more concerned about fees, but people will pay more for funds that can generate alpha or reduce volatility,” he says.

While some active funds should continue to thrive, they will face continuing pressure from index funds to lower fees. Recently index funds have been cutting their expense ratios to rock-bottom levels. Schwab S&P 500 Index (SWPPX) now charges 0.09 percent, while Vanguard S&P 500 ETF (VOO) imposes a microscopic expense ratio of 0.06 percent. The low prices are attracting the attention of investors and causing actively managed funds to follow suit. Hartford Financial Services Group recently cut costs on some of its bond funds, while Putnam lowered the fees on its absolute return portfolios.

According to Strategic Insight, average fees on active funds have been drifting down for some time. The expense ratio on active international equity funds dropped from 1.12 percent in 2005 to 1.08 percent in 2009. During the same period, fees on domestic equity funds fell from 0.95 percent to 0.92 percent.

Strategic's Fox says average fees are falling partly because financial advisors and their clients are becoming more sophisticated about expenses, and new money is gravitating to low-cost funds. To make the grade with such demanding customers, active funds will have to continue reducing costs — and delivering strong performance that even Internet bloggers cannot ignore.