Index Funds or Actively Managed: Which Is Right for You?

Research shows that over the long term, the returns of actively traded mutual and exchange-traded funds rarely beat passive index funds.

For 20 categories of funds tracked by Morningstar, the returns from only two of the actively managed funds matched or beat their passive counterparts in the 10 years through 2021.

A total of 54.4% of actively managed diversified emerging-market funds outperformed passive during the period. And 50% of global real estate funds outperformed.

For the past 20 years, none of the actively managed funds in 11 categories tracked by Morningstar beat their passive counterparts.

In the short term, 2021 was a booming year for many asset categories, including stocks and bonds. Actively managed funds in eight of 20 of Morningstar’s categories beat passive.

Active Struggled in July

But looking even more short term, the results for actively managed funds weren’t pretty. 

In July, the best month for the S&P 500 since November 2020, a bit more than a quarter (28%) of large-capitalization active mutual fund managers beat their Russell 1000 benchmarks, according to Bank of America.

That’s “the lowest hit rate since March 2022 and a sixth percentile hit rate in our data history since 1991,” Bank of America strategists wrote in a commentary.

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“The average fund lagged by 76 basis points [0.76 percentage point]. All three fund styles (core, growth, value) underperformed their benchmarks.”

Bank of America’s explanation for the lagging performance by active managers: “investors’ bearish stance” on stocks despite the market’s rise. Investors devoted a 6.1% weighting to cash during July, according to Bank of America, the highest level since 2001.

In addition, active funds’ 2-percentage-point overweight in high-quality stocks detracted from performance in July, the strategists said. That stemmed from the 2-point underperformance by high-quality versus low-quality stocks.

Implications for Individual Investors

The bottom line for individual investors seems to be that investing in passive funds makes the most sense for the long term. 

Passive funds generally have substantially lower fees than their actively managed counterparts. That creates a hurdle for active managers to outperform.

Some active managers do beat their indexes, but doing so for a long time is difficult. 

Bill Miller holds the record for broadly diversified large-cap funds, beating the S&P 500 for 15 years in a row, 1991-2005. But even he has had rough patches since then.

Warren Buffett’s Berkshire Hathaway  (BRK.B) – Get Berkshire Hathaway Inc. Report, which is essentially a fund manager, has trailed the S&P 500 for the past three-, five- and 10-year periods. Buffett himself has recommended that investors stick mostly to index funds.

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