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Index Funds Still Beat Most Managers

Think your mutual fund manager has what it takes to beat the market? If so, some new data from Standard & Poor's may make you think twice.

The mid-year S&P Indices Versus Active Funds Scorecard (SPIVA) shows that, with few exceptions, index funds have dominated their actively managed counterparts. As one example, over the past year, the S&P Composite 1500 beat 89.84 percent of all actively managed domestic stock funds. Over the past three and five years, those numbers were 73.24 percent and 67.72 percent, respectively. (For the purposes of the latest Scorecard, all returns are as of June 30, 2012.)

[Read: Understanding Your Mutual Funds' Portfolios]

"There is nothing novel about the index versus active debate," the new SPIVA report notes. "It has been a contentious subject for decades, and there are a few strong believers on both sides, with the vast majority of investors falling somewhere in between."

However, the Scorecard would suggest that on the aggregate, passive investors have the better argument. "[T]he trend of a large percentage of managers failing to outperform their benchmarks over a longer-term horizon remains consistent," according to the report.

This holds true for both stock and bond funds. "Over the last five years, the majority of active equity and bond managers in most categories lagged comparable benchmarks," the report notes. Indeed, for bond funds, the "five-year data is unequivocal." Take, for instance, actively managed long government bond funds. Over the past five years, 93.62 percent of them trailed the Barclays Long Government index.

[Read: How Much Confidence Do You Have In Your Mutual Fund Lineup?]

There are, of course, some exceptions to the general trend of outperformance. Take, for instance, large-cap value funds. Over the past five years, more than 60 percent of active funds in that category beat the S&P 500 Value index. But if you look at just the past year, that number drops to just over 27 percent.

So how does all of this translate into returns? Particularly in the realm of fixed income, the results are striking. For instance, the average asset-weighted return for actively managed long government bond funds over the past year was 8.98 percent. By comparison, the Barclays Long Government index returned 31.4 percent. Over time, however, these differences become less pronounced. Over the past five years, that particular benchmark beat actively managed funds in its category by a margin of 11.92 percent to 7.14 percent.

As for stock funds, the differences are often narrower, but they are nonetheless substantial. The average asset-weighted return for domestic stock funds over the past five years is zero percent. For the S&P Composite 1500, the five-year return is 0.46 percent. Sometimes it's the difference between being in the red and being in the black. Over the past five years, the average asset-weighted return for domestic large-cap core funds is a negative 1.08 percent. Over that time period, the S&P 500 returned 0.21 percent.

[Read: How to Pick the Best Index Fund]

None of this is to say that your particular fund won't beat its benchmark. Indeed, many of the active funds that consistently underperform their benchmarks are precisely the ones that conscientious investors who have done their research will avoid. But the point is that having a manager making buy and sell decisions, even when those decisions appear to be thoroughly supported, doesn't guarantee you better performance. Instead, statistically speaking, it would appear that it actually lowers your odds.

If you decide that active investing is not for you, index mutual funds and exchange-traded funds offer low-cost alternatives to actively managed funds. However, just as not all active funds are the same, not all index funds behave as they are supposed to.

Before investing in an index product, consider not only its past performance, but also how closely it has tracked the index it is supposed to be replicating. Particularly in the case of large indexes, funds may "sample"--meaning they invest in some, but not all, of the holdings that make up the underlying index. Some funds do that more effectively than others.

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