Why Investors Are Flocking to Index Funds

Lately, investors have voted with their feet and chosen indexing over actively managed funds.

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Since the dawn of indexing, a debate has raged between indexing diehards—who think passive investing is the only way to match the market over time—and those who believe that real, live stock pickers can do the job better. It may just come down to your personality. Indexers prefer a rather boring but fairly steady method, while others are enticed by the prospect of the sizeable gains active managers can achieve. When it comes to constructing a portfolio, every investor faces the same question: Do I trust a manager to pick the best stocks or put my faith in an index fund?

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Lately, investors have voted with their feet and chosen indexing over actively managed funds. Huge losses in the stock market in 2008 prompted many investors to sell actively managed stock funds. During that year, investors withdrew more than $214 billion from actively managed stock funds, while stock index funds saw inflows of more than $47 billion, according to Morningstar. The trend continued in 2009, with investors withdrawing more than $37 billion from actively managed stock funds and about $36 billion flowing into stock index funds.

[See How to Pick the Best Index Fund.]

Some experts say the best way to view this shift is from a cost perspective. Francis Kinniry, a principal in Vanguard's investment strategy group, says investors are undergoing a fundamental change in how they approach their portfolios. "Investors used to focus on historical performance or manager tenure, but now the research shows money is going into low-cost funds," Kinniry says. As of Dec. 31, 2009, 10-year cumulative cash flows show that the two least expensive quartiles (based on expense ratios) of actively managed funds attracted $170 billion in inflows, while the two most expensive quartiles saw outflows of about $90 billion, according to Kinniry's research on the subject.

On average, index funds are cheaper than actively managed funds. The average annual fees for an actively managed U.S. stock fund are 1.41 percent, compared with 0.90 percent for an index fund, according to Morningstar.

A decade of lackluster returns—referred to as the "lost decade"—may also help explain the rise of indexing. Lower returns may have spurred investors to question the abilities of active managers, many of whom lost large amounts in the two bear markets of the past decade. In the two previous decades (the 1980s and 1990s), the stock market gained much more—an 18 percent compounded annual return, according to Kinniry. "I don't think the focus was much on costs, and many investors were happy just getting a relative return of 16 or 17 percent," he says. "It didn't matter that they could have gotten 18 or 19 percent in an index fund."

The inflows may favor index funds, but the majority of fund investors' money is still in actively managed funds. Since an index fund aims to mimic the returns of the index it tracks—and since indexes tend to be broadly diversified—investors can expect their investment to rise or fall in tandem with an index. Critics say index funds don't have enough potential for high returns. "I contend that if you buy an index fund, you're accepting mediocrity," says Adam Bold, founder of the Mutual Fund Store. "You also know you will never do better than the index."

Bold adds that now, as the economy is recovering, it's crucial for investors to go with actively managed funds because managers can pick and choose the companies that are most poised for a recovery. "Look at General Motors, which went bankrupt," Bold says. "The managers of S&P 500 funds had to hold that stock until they day it went out of business because it was still in the index."

Those on the other side of the aisle argue that although an index fund by definition will never outperform its index, only a small percentage of active managers beat their benchmark index—which a given fund is measured against—every year. Kinniry says that over the long term, indexing typically outperforms active management 60 to 70 percent of the time.