Managed vs. index funds

Investors face a similar head-scratcher when it comes to choosing between the index (or passive) mutual funds you drive and actively managed (or active) funds that leaves the driving to others. Both can get you where you want to go -- a financially sound retirement -- but chances are you'll prefer one ride to the other.

"There's just not a one-size-fits-all portfolio or rule of thumb," says Sonya Morris, fund analyst for Morningstar. "It's going to depend on the investor's risk tolerance, objectives and time horizon."

The debate over index versus actively managed funds has raged so long without resolution that it has taken on the rich patina of the great sports rivalries. As with all great rivalries, both sides are relatively evenly matched, have their unique strengths and weaknesses, and prevail and disappoint in about equal measure.

Here are the team line-ups:

Index funds
Index funds invest in equity or fixed income securities specifically to replicate indexes such as the Standard & Poor's 500 or Lehman Brothers U.S. Aggregate. Index funds are recommended as solid, long-term core investments.

Strengths: Because the holdings in these funds are closely tied to their respective indices, there is little in the way of buying and selling (called "turnover") or management involved, resulting in minimal cost to investors. For example, the popular Vanguard 500 Index fund charges just 18 basis points (0.18 percent) in fees. Index funds also are well diversified and easy for even a novice investor to purchase.

Weaknesses: Because index funds by nature do not correct for market conditions, they passively go in the direction of the market, both up and down. This can sometimes try the patience of investors, particularly during periods of volatility.

Some financial advisors, including "Die Broke" author Stephen Pollan, find index funds safe but pretty ho-hum.

"Index funds do not have the advantage of having stocks picked for quality, for performance at the time," he says. "Bringing this down to basics, index funds are cheaper but you're missing good judgment."

Actively managed funds
As their name implies, actively managed funds invest in equity or fixed income securities based on the recommendations of a single manager or management team, who charge a fee for their services.

Strengths: Fund managers sell their services on their ability to "beat the street" with a number of tools: more focused and up-to-date research, in-depth knowledge of particular market sectors, constant monitoring of market conditions and the ability to respond quickly to market changes.

Weaknesses: Management comes at a price. Typically, actively managed funds cost in the 1 to 3 percent range. As a result, they must not only equal the performance of their fund benchmark, but exceed it by more than their fee in order to actually "beat the street."

"You shouldn't always assume that managed funds are better funds -- absolutely not," says Morris. "The vast majority of active fund managers have a tough time beating their benchmarks in the long haul."

Past performance is no guarantee...
To echo the ubiquitous investment disclaimer, past performance is no guarantee of future results when it comes to either mutual fund style. But how have the rivals historically fared against each other?

Finance professors Stuart Michelson of Stetson University in Deland, Florida and Rich Fortin of New Mexico State University at Las Cruces studied active verses index fund returns over two periods, 1975 to 2000 and 2000 to 2005. The study, published in the , used net return figures, meaning active fund managers had to cover their fees as well.

The study found that, on average, index funds outperformed actively managed funds across the board, with the exception of two sectors: small capitalization stocks and international funds.

"If the market is moving a great deal up or down, but especially down, your index funds are going to be moving along with the market," says Michelson. "It's just that potentially the managed funds are going to be even worse than that."

Morningstar's Morris says fund managers have traditionally fared best in sectors where extra research and analysis can sometimes turn up market inefficiencies.

"In emerging markets, for instance, if you have a fund manager who has several analysts, boots on the ground in the country of interest, I think he's got the advantage, and possibly the ability, to add some incremental value there."

Not surprisingly, active fund managers fared better during periods of market instability.

Actively managed funds
As their name implies, actively managed funds invest in equity or fixed income securities based on the recommendations of a single manager or management team, who charge a fee for their services.

Strengths: Fund managers sell their services on their ability to "beat the street" with a number of tools: more focused and up-to-date research, in-depth knowledge of particular market sectors, constant monitoring of market conditions and the ability to respond quickly to market changes.

Weaknesses: Management comes at a price. Typically, actively managed funds cost in the 1 to 3 percent range. As a result, they must not only equal the performance of their fund benchmark, but exceed it by more than their fee in order to actually "beat the street."

"You shouldn't always assume that managed funds are better funds -- absolutely not," says Morris. "The vast majority of active fund managers have a tough time beating their benchmarks in the long haul."

Past performance is no guarantee...
To echo the ubiquitous investment disclaimer, past performance is no guarantee of future results when it comes to either mutual fund style. But how have the rivals historically fared against each other?

Finance professors Stuart Michelson of Stetson University in Deland, Florida and Rich Fortin of New Mexico State University at Las Cruces studied active verses index fund returns over two periods, 1975 to 2000 and 2000 to 2005. The study, published in the Journal of Financial Planning, used net return figures, meaning active fund managers had to cover their fees as well.

The study found that, on average, index funds outperformed actively managed funds across the board, with the exception of two sectors: small capitalization stocks and international funds.

"If the market is moving a great deal up or down, but especially down, your index funds are going to be moving along with the market," says Michelson. "It's just that potentially the managed funds are going to be even worse than that."

Morningstar's Morris says fund managers have traditionally fared best in sectors where extra research and analysis can sometimes turn up market inefficiencies.

"In emerging markets, for instance, if you have a fund manager who has several analysts, boots on the ground in the country of interest, I think he's got the advantage, and possibly the ability, to add some incremental value there."

Not surprisingly, active fund managers fared better during periods of market instability.

"There were years where they did beat the index funds, during those more turbulent years," says Michelson. "When you have those changing economic times, when you do look at your good fund managers, they're realigning their portfolio along with that."

Few heroes in active funds
Broad-brush results can be misleading, however. Although the study found that a majority of fund managers fail to pay for themselves and "beat the street," Morris says a few talented ones do so with some consistency. The trick is finding one.

"There are very few such talented managers; they're out there, but it takes time and effort to find them," she says.

To some degree, your investment style and objectives will dictate which approach best suits you. Indexing is a long-term strategy; you want to stay invested with your eye on that distant prize and not be detoured by short-term opportunities or market corrections. Actively managed funds, conversely, require a bit more daring and risk tolerance.

Michelson's advice: "Your first move ought to be into index funds because they're going to outperform the managed funds in general. Then diversify into some other areas -- small caps, internationals, bonds and real estate."

Pollan, however, prefers the earning potential of managed funds to the risk-avoidance of index funds.

"Should you have a percentage of your core in index funds because for the last 100 years the market has done well? That's like saying you should have a certain amount in cash. I think that's true from the point of view that you are reducing your risk, but if you want to be an active investor, you concentrate on what is being managed."

Morris maintains that index funds have one proven advantage over managed funds: "The expense ratio is one of the few data points we've found to be predictive of future performance; the lower the expense ratio, the better the performance, all things being equal," she says. "That gives index funds a huge advantage. They also keep their costs lower in another way; most index funds have low turnover, so that means their trading costs are also low."

Her advice: Don't be afraid to mix index and active funds. If you enjoy investing, there's a wealth of information, including analyst picks, available at Morningstar.

"If someone wants to manage their own portfolio but they want a fairly low-maintenance portfolio that they don't have to spend a lot of time looking at, I think index funds can be a great way to go," she says. "But you might be well advised to seek out a good financial adviser that you trust to help you locate the funds that will meet your needs, and there may be active funds in that mix. Both an active fund and an index fund can meet an investor's needs."