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Popular Index Funds Perform Poorly

NEW YORK ( TheStreet) -- Passive investing was once an arcane idea, but in recent years millions of investors have embraced index funds and exchange traded funds.

Passive funds climbed from 3% of all mutual fund assets in 1995 to 20% today. Academics have applauded the shift, arguing that index funds consistently deliver above-average results. Over long periods, index funds beat active funds by wide margins, the academics say.

In many business schools, the conventional wisdom has become that index funds are the choice of sophisticated investors, while only unschooled chumps stick with actively managed funds. But the academics have exaggerated the benefits of passive investing. The reality is that many index funds have delivered poor returns. In many instances, investors would be better served by using active funds.

To appreciate the performance of passive investing, consider that Morningstar tracks 133 domestic equity index funds with 10-year records. Of those funds, 67 finished in the bottom half of their Morningstar categories. Among the losers were Vanguard Small Cap Value (VISVX), which trailed 77% of its small-value peers, and Legg Mason Batterymarch S&P 500 Index (SBSPX), which lagged 63% of large-blend funds.

Other index funds that finished in the bottom half included Schwab Small Cap (SWSSX), T. Rowe Price Equity Index 500 (PREIX) and Calvert Social Index (CSXAX). Many index funds that finished in the top half delivered uninspiring performances. Vanguard 500 (VFINX) trailed 47% of competitors and Fidelity Spartan 500 (FUSEX) lagged 46%. Results for international equity index funds were also mixed. Vanguard European Index (VEUSX) fell short of 68% of peers, while BlackRock International Index (MDIIX) fell behind 59%.

Despite the mixed record, index funds have gained support partly because proponents have used studies in misleading ways. In a book published in 1999, Vanguard founder John Bogle noted that in the preceding 20 years, the S&P 500 outdid 79% of all active funds. From this, proponents of passive investing concluded that active funds were worthless. Academics noted that active funds ran hot and cold, while index funds were consistently superior.

But the academic conclusion was flawed. Because it focuses on large stocks, the S&P 500 is a poor benchmark for many funds that hold small- and mid-cap stocks. During the 1990s bull market, a few big stocks in the S&P 500 soared. That made the benchmark difficult to beat. Not surprisingly, small- and mid-cap funds trailed badly. Large-cap funds that didn't concentrate on the hottest stocks also lagged. But in the past decade, the situation reversed. Mega-cap stocks lagged, and small-cap funds soared. By holding some mid-cap stocks, large-cap funds could easily top the S&P 500. The recent performance underlines that index funds are erratic, running hot and cold like active funds.
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