Index funds vs managed funds. Which performs best ?

Ever since Jack Bogle of Vanguard created the first index fund in 1976, there has been continuous debate over which type of fund is more effective – index funds or managed funds. In their early years indexes struggled to gain traction, but now make up 45% of the entire fund market in the U.S, up from 25% a decade ago.

Index vs managed funds performance

The SPIVA 2018 mid-year report revealed that over a 15 year period 92% of large cap, 95% of mid cap and 97% of small cap fund managers underperformed on a relative basis. Put another way, fewer than 8% of managers outperformed the market over the given timespan. This means that by investing in low cost passive index funds you can outperform 92% of high charging managed investment funds.

In 2019 a Morningstar report of active vs passive funds revealed that only 23% of active funds outperformed indexes over a 10 year period. On top of this, the lowest cost funds outperformed more than twice as often as more expensive funds.

A further report by WM Company discovered that over a 20 year period 82% of managed funds failed to outperform the market. However, this figure excludes funds that were either merged or shut down so the true figure will be higher.

An article from IFA.com shows that over 3 years the S&P500 index outperformed 98% of fund managers and 97% over 10 years ending in 2004. Additionally, it outperformed 97% and 94% of managers respectively in two 30 year studies. Further, out of the top 100 fund managers only 12% repeated their performance in the years that followed.

An analysis of superstar fund managers by Nobel Laureate Paul Samuelson concluded that there was no easily replicated strategy that could guarantee outperformance. A further study by professor Martin Gruber exploring why there is an apparent increase in managed funds despite their underperformance concluded:

  • managed funds underperform their benchmark indexes by 65 basis points annually
  • Their expense ratios are beyond the value which managers can add
  • managed funds are outperformed by index funds due to lower expense ratios

Even legendary investor Peter Lynch of the renowned Magellan fund has said “All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage”.

index funds

The importance of fund costs

The growing shift towards indexes has been driven by increased consumer financial awareness combined with the desire to reduce fund management costs. Bogle’s own analysis of actively managed funds vs index funds revealed that fund expenses resulted in 92% of the weakness in investment performance relative to the benchmark market index. Hence your total investment return is strongly affected by the overall costs of any given fund.

Vanguard’s own research shows that fund costs are such a determining factor in absolute return. that it is much less likely that a managed fund with higher costs will outperform either the market or a low cost index fund. They go even further, by saying that as costs rise in managed funds significant underperformance is as expected, or more expected than a small level of outperformance.

The majority of managed funds also underperform their benchmarks, exposing that negative excess returns are more likely than positive once fund costs are accounted for.

A report by Financial Research corporation in 2002 analysing fund metrics and historical returns concluded that the expense ratio of a fund is the most accurate predictor of future performance. In 2010 a Morningstar report covering it’s full range of funds concluded that low expense ratios were the best indicator of fund outperformance. In 2019 they added “If there’s any guidepost that investors can use, it’s fees”…”The lowest cost funds in any given category had above average odds of beating their index”.

Fund costs are not an issue that solely apply to managed funds either. A 2015 report by Rowley and Kwon looked at a range of metrics across ETF’s and index funds and concluded that expense ratio was the most critical factor in determining a funds excess performance. They added that the negative correlation between fund charges and excess return clearly implies to investors that selecting low cost funds gives you the highest probability of outperforming higher charging funds.

They added that since actively managed funds are by their nature performing more transactions and thus incurring more costs, this ‘cost drag’ combined with the higher fees of managed funds are a bigger hurdle for a manager to overcome and gain outperformance, compared to the low operating costs of an index fund.

They also noted that after taking into account funds which had previously merged or been closed down, underperformance was more consistent than over-performance across all asset classes. Further, they said that through analysing global markets it is quite clear that consistent outperformance from a fund manager is very hard to attain. Whilst it can be seen that there are some managers that do outperform reasonably consistently, they are extremely rare. Overall though as a group, over time, and on average, active managers fail to outperform.

A typical managed fund has annual fees of 1.5%, sometimes considerably higher. There can also be ‘performance fees’ levied on some funds as well as ongoing transaction costs. An index tracker fund by comparison has typical fees of around 0.25% but can be considerably lower, down to around 0.05%. Over time and with the effect of compounding this can make a big difference to investment returns.

Managed funds in the U.K usually rotate around 50% of their portfolio holdings annually compared to 20% for an index. The additional dealing costs and taxes connected with this process mean that active funds have extra challenges to overcome to attempt to outperform an index.

The importance of time in performance return

Time is a critical factor in investing. Whilst a managed fund could have a ‘good year’ and outperform, the ultimate test is how a fund can perform over the longer term.

An index fund has 2 main advantages over the long term:

  • lower expense ratios
  • consistent average underperformance by managed funds

Short term performance reports will mask the effectiveness of index funds because the influence of their low costs compound over longer time periods. Comparing two funds over a year will not reveal the benefit of low cost compounding, but over 5, 10 or 20 years it will make a significant difference.

When can managed funds be a viable option?

Although there are a great deal of index funds, there may be examples of investment areas which are not represented by an index and a managed fund is the only option. Also, your broker or pension company may not offer the relevant index funds you may be interested in.

A Morningstar report concluded that if you are still determined to invest in managed funds then there are key fund categories you should consider. It showed that over 10 years, 82% of foreign small-mid cap funds and 61% of corporate bonds outperformed their passive equivalent, but only 8% of large blends did.

It also laid bare that 66% of low cost bond funds versus 29% of high cost outperformed their benchmark, indicating that bond fund charges appear to be even more critical in overall performance compared to stock funds.

Research from William Harding and Brian Portnoy has also indicated fund types where active management performs best. Over a 10 year period up to 1991 small and mid cap growth and small cap blended funds have the best results for beating their benchmark indexes, even after expenses.

They also discovered that managed funds perform better in erratic or bear markets but worse in bull markets compared to index funds. Small cap funds performed best in terms of beating their benchmark but mid cap funds were the most consistent overall outperforming their benchmark by roughly 50% in both good and bad years.

Index funds vs managed – conclusion

The evidence is overwhelming that passive index funds will outperform over 90% of actively managed funds. For the average or even experienced investor, this means your life can be made very simple by minimising the whole process and investing in a low cost tracker fund to avoid all the necessary time and research involved in trying to discover that elusive ‘star’ fund.

Whilst it has been shown that there are managed funds that do outperform, very few do it consistently, and statistically it is likely to be due more to chance than via exceptional stock-picking ability for all but the rarest of managers. With the additional hurdles of higher fees and extra transaction costs that they need to surpass, the odds are stacked against you compared to an index.

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