Should You Invest in Actively Managed or Index Funds?

Low-cost index funds tend to outperform most actively managed funds over time. One smart solution: Strike a balance between the two.

(Image credit: scyther5)

This is the month when we present our annual rankings of mutual funds, in which actively managed funds predominate. So it may seem counterintuitive that we’re also featuring a story on indexing, which is all the rage among investors. As senior associate editor Nellie Huang observes in her story, actively managed funds consistently struggle to beat the indexes. Over the past 15 years, only 35% of actively managed large-company U.S. stock funds have beaten Standard & Poor’s 500-stock index. Little wonder that since 2010, investors have withdrawn a net $500 billion from actively managed U.S. stock funds and invested that amount in index-tracking mutual funds and exchange-traded funds. In a recent page one headline, the Wall Street Journal announced “The Dying Business of Picking Stocks.”

So why bother with the rankings? For one thing, there’s the perverse nature of the market. “It’s usually not a good sign when everyone is bullish on an investment or strategy. You can bet that that investment or strategy is doomed to fail or is at least headed into a period of disappointing performance,” says executive editor Manny Schiffres, who supervises our investing coverage.

That truism is on full display in the rankings themselves. For much of the past few years, the big winners were funds that focused on large-company growth stocks. But in 2016, the best-performing category among domestic stock funds was small-company funds, followed by mid-cap funds. And funds that focused on bargain-priced value stocks, which had been in the dumps, started to perk up. Says Manny, “One of the main takeaways of 2016 was that big investment trends don’t remain in place forever.”

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The human factor

That should give some comfort to investors who worry that a big shift to indexing would somehow distort markets and stock prices. After her extensive reporting, Nellie concluded that even indexing fanatics say there’s no way the market will ever convert to indexing alone. Even indexing giant Vanguard has 72 actively managed funds. And, she notes, “if 99% of funds were to go the index route, then active managers might suddenly outperform.”

There’s also human nature, which can’t help striving to beat the market. As an example, Nellie cites ETFs, which started out using traditional indexes based on company size but have since morphed into “smart beta” funds in an effort to get an edge—for instance, by weighting companies equally or focusing on firms with fast-growing revenues.

And then there’s the fun factor. “It’s fun for me to invest,” says Nellie, “and I don’t want to be all-index.” When Kiplinger’s interviewed indexing advocate and financial icon Burton Malkiel, he revealed that he had purchased shares of Alibaba, the Chinese e-commerce company, after it went public.

Still, it’s hard to refute statistics showing that low-cost index funds tend to outperform most of their active brethren over time. One smart solution: Strike a balance between active and index funds. Keep your core portfolio (the actual portion is up to you) in broad-based index funds that track the S&P 500 or a total-market benchmark, and complement it with low-cost active funds with stellar records (see Nellie’s story for our favorites).

With interest rates on the rise, some analysts think there will be more divergence in how companies perform and more opportunities for active investors. This could be the year in which the dying business of picking stocks gets a shot in the arm. Either way, you’ll be prepared.

Janet Bodnar
Editor-at-Large, Kiplinger's Personal Finance
Janet Bodnar is editor-at-large of Kiplinger's Personal Finance, a position she assumed after retiring as editor of the magazine after eight years at the helm. While editor, Bodnar was honored by Folio as one of its Top Women in Media. She is a nationally recognized expert on the subjects of women and money, children's and family finances, and financial literacy. She is the author of two books, Money Smart Women and Raising Money Smart Kids. As editor-at-large, she writes two popular columns for Kiplinger, "Money Smart Women" and "Living in Retirement." Bodnar is a graduate of St. Bonaventure University and is a member of its Board of Trustees. She received her master's degree from Columbia University, where she was also a Knight-Bagehot Fellow in Business and Economics Journalism.