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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.

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