Indexing Beats Active Management (Again)

One of the questions I get asked a good deal is this:

If my XYZ fund can earn the extra expense it charges, why shouldn't I pay more for active management instead of a (boring) index fund?

There are a number of reasons (more detail in an upcoming Advisor's Outlook), but one of the more compelling is highlighted by the most recent Standards & Poor's Indices Versus Active Funds Scorecard (SPIVA).

According to the report, the S&P 500 outperformed nearly 70% of actively managed large-cap funds in 2006 while charging only 1/6 the fees to do so. This means the average actively managed large-cap fund charged over 3/4 of 1% for only a 30% chance of beating its target.

If you're making that bet, what are you relying on to make certain you've picked one of the winning 30%?

Research? Presumably you've gone with mutual funds rather than stocks because you don't have the time or talent to separate the wheat from the chaff and have decided to pay a pro to do that for you; why do think you have time to do the research to find one of that 30% of funds that's a winner?

Marketing? Most marketing is geared to tout the hottest sector or hot fund of the quarter. Chasing hot hands is a losing strategy. Hot funds tend to cool off and (some) losers recover.

Track Record? The five-year track record is worse: Active large-cap funds lag 71.4% of the time, mid-cap 79.7% and small-cap 77.5%.

Don't pay more to get less. Stick with index funds.

For the full paper see: http://www2.standardandpoors.com/spf/pdf/index/SPIVA_2006_Q4-sc.pdf (requires Adobe)