This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Faith in Index Funds Rests on Flawed Research

NEW YORK ( TheStreet) -- Some proponents of index funds have been making extravagant claims. Index funds always outperform actively managed funds, the proponents say. Plenty of investors have been persuaded, and they are pouring money into index mutual funds and ETFs.

But in the past decade, many index funds have produced dismal results, lagging their category averages. Dozens of index funds have been liquidated or merged away. In a new study, Morningstar tracked the performance of index funds. In January 2001, there were 542 index funds. Over the next 10 years, only 25% surpassed their category averages. Of the rest, 30% went out of business and the others failed to outdo their category averages.

Among the laggards in the past 10 years was T. Rowe Price Equity Index 500 (PREIX), an S&P 500 fund that trailed 53% of large blend funds, a group that includes active and index portfolios. Another loser was Schwab Small Cap Index (SWSSX), which trailed 60% of small blend funds.

Much of the faith in indexing rests on flawed research. Widely quoted studies note that most actively managed funds have lagged benchmarks, such as the S&P 500. That is true. But the studies fail to note that the results of actively managed funds are dragged down by expenses. In contrast, the S&P 500 is a theoretical benchmark that does not include the expenses of the real world. To actually track the benchmark, you must hold an index fund, and those come with expense ratios.

While a handful of index funds charge tiny fees of less than 0.15%, the average index fund has an expense ratio of 0.62%, according to Morningstar. Many top active funds have expense ratios 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%, while iShares Dow Jones US Healthcare ETF (IYH) -- which tracks an index -- charges 0.48%. Elfun International Equity (EGLBX), an active fund, charges 0.27%, while Vanguard Total International Stock Index (VGTSX) charges 0.32%. Some bloggers say index investors are smart and the average person who uses an active fund is dumb, says Russel Kinnel, Morningstar's director of fund research. But there are high-cost index funds and low-cost active funds.

1 of 3

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!
IYH $155.63 0.00%
AAPL $124.75 0.00%
FB $80.78 0.00%
GOOG $524.05 0.00%
TSLA $206.79 0.00%


DOW 17,826.30 -279.47 -1.54%
S&P 500 2,081.18 -23.81 -1.13%
NASDAQ 4,931.8150 -75.9760 -1.52%

Partners Compare Online Brokers

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs