Low fees and simplicity are common selling points for index funds. But they also outperform many mutual funds and hedge funds after taxes and fees are deducted, a new study says. Mark Kritzman, chief executive officer of Windham Capital Management, calculated the average returns of three imaginary funds over a hypothetical 20-year period. Including fees and estimated taxes, index funds returned 8.5% a year on average, compared with 8% for actively managed mutual funds and 7.7% for hedge funds. Financial experts continue to debate over which investing method yields the biggest returns long-term. Funds that are actively managed rely on stock picking and asset allocation strategies to maximize returns. Index funds, on the other hand, are designed to track a market index with the help of computer models. When fees and taxes are excluded, the hypothetical hedge fund led the group with an annualized return of 19%. That compares with 14% for the theoretical mutual fund and 10% for the stock index fund, according to the study, published last month in the newsletter Economics & Portfolio Strategy. The big picture: The main upside to actively managed funds is their potential to generate better returns than the broad market. An experienced manager with the right resources can separate the best stocks from those with weak prospects. But they sometimes make poor decisions, pursue unsound strategies or shift their investing style unexpectedly. Index funds offer a straightforward and consistent investing approach, though they're designed to perform only as well as the indexes they track. That means that an actively managed fund that beats its benchmark index will also top the funds that follow that index.
The price of having an expert run your fund is reflected in higher expense ratios. Some actively managed funds deduct as much as 1.5% from returns as fees, compared with the 0.5% index funds typically charge. Index funds' advantages: Which fund type will earn you bigger returns in the long run? It depends on whether index funds' lower expenses make up for actively managed funds' potentially larger returns. Kritzman's research suggests that lower expenses lead to higher long-term returns. Similar studies in previous years have yielded comparable results. Moreover, the actively managed mutual fund and the hedge fund in the study needed to beat their index-based counterpart by far more to compensate for expenses. Specifically, the actively managed mutual fund would need to beat the index fund by 3.5%, while the hedge fund would have to outperform by a whopping 10%. However, just because one imaginary index fund beat two actively managed funds doesn't necessarily mean the same thing would happen in the real world. A complex web of factors influences any fund's returns. Kritzman used industry averages for volatility, turnover rates, and transaction and performance fees. The study would have turned out differently had he used funds with different characteristics or if he modeled his calculations on different tax rates. What this means for you: Do index funds' superiority mean you should dump your shares of actively managed funds? Not necessarily. First, the fees and tax implications of moving your assets around could be more than any savings that might come from lower expenses. You might also have an actively managed fund that would be hard to replace with an index fund.
Still, as you consider future moves, remember the lesson offered by Kritzman's study: A fund's expense ratio, not its past performance or its Morningstar ( MORN) rating, might be the best predictor of long-term performance.