Why Investors Are Flocking to Index Funds

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


Some experts say the decision to invest in indexes or actively managed funds depends on how much risk an investor is willing to take. For example, high-profile manager Bill Miller's Legg Mason Capital Management Value fund (symbol LMVTX) did the unthinkable: It outperformed the S&P 500 for 15 consecutive years (1990 to 2005). But the streak ended in 2005, and the fund struggled to beat its index until 2009, when it shot up 40 percent. (The Schwab S&P 500 Index fund returned about 26 percent in 2009.)

"With indexing, you aren't making short-term bets on the market, and you're also going to avoid the extremes," says Russel Kinnel, Morningstar's director of mutual fund research. "On the one hand, you're not escaping the bear market, but on the plus side, it may be the sort of thing that prevents you from having the portfolio-crippling loss." Research has shown that most of the best-performing actively managed funds have gone through periods of underperformance. Because there's no guarantee that an actively managed fund will be able to beat its index over the long term, investors who choose to put their money in one need to be prepared for an "emotional roller coaster," says William Thatcher, senior consultant at Hammond Associates in St. Louis, who recently published research favoring indexing.

Wherever you find yourself on the investing spectrum, it's important to choose funds with low expenses. The lower the fund's fees, the easier it is for a manager to outperform the market. "As people become more sophisticated and more disappointed with high-cost mandates, they're going to quickly realize what the sophisticated institutional money has been doing all along, and you're going to see a broader and broader base buying low-cost funds," Kinniry says.