A Case For Index Fund Portfolios

By
Richard Ferri and Alex Benke
January 03, 2014
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Portfolios of active funds versus portfolios of index funds.

This article appears in the January/February 2014 issue of the Journal of Indexes.

The success of index investing in individual asset class categories has been widely documented. However, surprisingly little research is available that compares the performance of diversified portfolios of index funds with portfolios of actively managed funds. The analysis has been hindered both by the relatively short length of time index funds have been available in most asset classes and a survivorship bias that existed in most commercially available mutual fund databases.

A prudent mutual fund selection strategy is important to an investor's wealth accumulation. Two distinct strategies are compared in this report: one that selects low-cost market-tracking index funds exclusively; and one that selects from actively managed funds that attempt to outperform the markets. Overwhelming evidence is found in support of an all-index-fund strategy.

The research is unique in that the actual performance of index funds and actively managed funds are used throughout the study. Each portfolio was formed using the CRSP Survivor-Bias-Free US Mutual Fund Database, which includes funds that have failed or merged over the years. This robust database enabled the replication of the real-world experience of investors who could not forecast which funds would survive at the time they made their investment decisions.

The outcome of this study favors an all-index-fund strategy. The probability of outperformance using the simplest index fund portfolio started in the 80th percentile and increased over time. A broader portfolio holding multiple low-cost index funds nudged this number closer to the 90th percentile. These results have significant and practical implications for investors seeking a strategy that can give them the highest chance of reaching their investment goals.

Summary Of Findings
Mutual funds and exchange-traded funds (collectively, "funds") can be divided into two broad categories: passively managed index funds1 that attempt to track the performance of a market or market sector less a small expense; and actively managed funds that attempt to outperform a market or market sector net of expenses.

Investors have a wide choice of funds today. Index fund providers and actively managed mutual fund companies have redundant funds that span the global markets. All the major asset classes are well covered.

Studies referenced in this paper show that index funds have outperformed a majority of active funds in their respective investment categories. These studies, conducted over decades, have shown that index funds have outperformed the average actively managed fund in all equity and fixed-income markets, both in the U.S. and abroad.

It's natural to expect that a portfolio holding only index funds would outperform a comparable portfolio that holds only actively managed funds. Surprisingly little research has been done to test this hypothesis. There are only a handful of studies on mutual fund portfolio performance, and only one that has measured actual index fund portfolio performance relative to actual actively managed fund portfolio performance.2

The index fund portfolios used in this study are composed of index funds that existed over the entire period. These funds were available to all individual investors at all times. These index fund portfolios were compared with randomly selected actively managed fund portfolios chosen from a universe of funds that were also available to all investors over the same period.

 

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