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.
Index proponents have been particularly enthusiastic about Vanguard funds, which have received huge inflows. But Vanguard's best performers have been its actively managed funds. Of the 23 Vanguard active stock funds with 10-year records, 16 have outperformed their benchmarks. In many cases, the active funds have been clearly superior to the competing Vanguard index funds. During the past decade, Vanguard Capital Opportunity ( VHCOX), a large growth fund, returned 6.7% annually, while Vanguard Growth Index ( VIGRX) only rose 3.7%. In the same period, Vanguard Equity Income ( VEIPX), a large value fund, climbed 4.9%, while Vanguard Value Index ( VIVAX) gained 3.4%. The success of the Vanguard active funds underlines the importance of low expense ratios. Expenses are the single most powerful predictor of future returns. On average, funds with low expense ratios beat those with high expense ratios. This is true whether the funds are passive or active. In Vanguard's case, the expense ratios of the active funds are extremely low and about the same as the figures for index funds. That has made it easy for Vanguard's adept active managers to top competing passive portfolios. A few index funds charge small fees of less than 0.15%, and the funds can be sound investments. But the average index fund has an expense ratio of 0.62%. Many top active funds have fees that are comparable to the index average. For example, Vanguard Health Care ( VGHCX), an active fund, has an expense ratio of 0.36%, while iShares Dow Jones U.S. Healthcare ETF ( IYH), which tracks an index, charges 0.48%. So odds are that the Vanguard fund will outdo the ETF in the future. Index proponents remain unimpressed with the success of top active funds like Vanguard's and say there is no good way to pick active funds. As the boilerplate says, past performance does not guarantee future results. But there are sensible ways to pick active funds. Academic studies have shown that Sharpe ratios can provide some guidance. Instead of looking at only performance, the Sharpe ratio considers risk-adjusted returns, or how much return a fund delivered considering the risk that it took. The Sharpe system penalizes high-risk funds that jump around erratically and can record big losses.
Searching for ways to select funds, Morningstar recently looked at Sharpe ratios as well as Morningstar's own star rating system, which relies on risk-adjusted past performance. The Morningstar researchers found that risk-adjusted past performance can have some predictive value. But the researchers determined that investors can increase the odds in their favor by considering both risk-adjusted returns and expense ratios. Funds that had low costs and strong risk-adjusted returns were likely to do well in the future. Picking active funds requires making subjective decisions. You must strive to find funds that seem to have a sensible investment approach that is likely to thrive in the future. But by sticking with managers that have long records of consistent success, it is possible to find funds that deliver sound returns. A top choice is Parnassus Equity Income ( PRBLX), which has returned 7.4% annually during the past 10 years, outdoing 99% of its large-blend peers and topping the S&P 500 by 4.7 percentage points annually. Working hard to limit risk, manager Todd Ahlsten excels in downturns. The fund topped the S&P 500 by wide margins during the downturns of 2000 and 2008. Parnassus holds reliable performers, such as Microsoft ( MSFT) and Nike ( NKE). Another steady performer is Mairs & Power Growth ( MPGFX), which has returned 7.3% annually during the past decade. Manager William Frels looks for rock-solid companies that can grow consistently. Holdings include blue chips, such as cereal maker General Mills ( GIS) and device maker St. Jude Medical ( STJ).
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