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.

Should you avoid index funds? Hardly. Low-cost index funds can be efficient. But it is important to keep in mind that all funds -- "whether index or active" -- have strengths and weaknesses. Russel Kinnel says he owns a mix of index and active funds. If you are a savvy investor who looks for low-cost funds, you can do well with either index or active funds, he says.

Many investors have been shifting to index funds lately for the wrong reasons, says Kinnel. He notes that in 2008 the S&P 500 lost 37%, and active funds performed about in line with the benchmark. Investors had reason to be disappointed with funds of all kinds, but much of the ire focused on active portfolio managers. "Investors thought that portfolio managers should have shifted to cash before the downturn," says Kinnel.

But the idea that managers can time the market perfectly is unrealistic, says Kinnel. Under SEC rules, most funds are not permitted to make massive swings to cash. Funds must live up to their names. So if a fund has the term "small-cap" in its name, it must keep 80% of the portfolio in the asset class. Such funds are bound to sink in market downturns.

Just as the exodus from active stock funds was motivated partly by irrational considerations, investors have also been making panicky moves with bond funds. While active stock managers about matched the benchmarks in 2008, active bond funds trailed badly. In 2008, the Barclays Capital Aggregate bond index gained 5.2%, and the average intermediate-term bond fund lost 3.7%. Even PIMCO Total Return ( PTTAX), which is run by bond star Bill Gross, gained only 4.3% and trailed the benchmark by 0.9%.

You would think that angry shareholders should have dumped the PIMCO fund and shifted to index funds like Vanguard Total Bond Market Index ( VBMFX), which returned 5.1% for the year. Instead, shareholders decided that Gross was a hero at a time when stocks had lost so much. Investors promptly poured tens of billions of dollars into active funds from PIMCO and other companies.

Is it a mistake to buy the PIMCO fund? Not necessarily. Gross has surpassed the benchmark over a career that spans decades, and he deserves his star reputation. But many investors who chose the actively managed bond funds were acting out of panic, not rational thought.

The timing of many investors was terrible. Since markets hit their low in March 2009, actively managed stock funds have soared. Many active funds that suffered big withdrawals have outpaced bonds and stock index funds by comfortable margins. Instead of panicking, investors should have acted carefully, buying sensible funds and holding for the long term.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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