How index and active funds stack up

(MoneyWatch) "What does your fund manager do?" screamed the headline of the April 8 edition of Barron's. All I could think was, "What, indeed!" The article says some superstar fund managers "fly around the world, they crunch reams of data, they dissect industries" -- and, for good measure, ultimately beat the index against which their funds are measured.

Here's the problem: Even if there are some diamonds in the rough (and believe me, it's rough out there in managed mutual fund land!), it may not even be worth trying. The reason is that it is very difficult to beat the index after factoring in costs and fees.

A recent survey by the London investment firm Style Research analyzed 425 global equity funds versus the MSCI World index. Without fees, 59 percent of the managers beat the index. However, after investor fees were included, only 31 percent beat the index last year.

And it gets harder to beat year after year, because investors tend to pile into the good funds only after they have beaten their relative indexes. Once new money flows into these funds, costs tend to rise and the funds can get too large and cumbersome for the manager, which together make outperformance more difficult to achieve in the future.

There has been some good news on fees. According to the Investment Company Institute, mutual fund fees have been trending lower. The average expense ratios for equity funds have fallen from 0.99 percent in 1990 to 0.79 percent in 2011, a 20 percent decline. But a good chunk of that decrease may be attributable to the shift toward no-load (no commission) funds. Actively managed equity funds still have average fees of 0.93 percent, while index equity funds have average fees of 0.13 percent.

How do you find the good ones? It will take some work. You will need to identify active investment managers with a proven track record who can consistently stick to an articulated and prudent strategy. You will also want to look for a fund with low investment costs and administrative and advisory fees; also watch out for costs due to portfolio turnover, commissions and execution.

If you prefer to spend your time in other ways and want to make your investment life a little easier, there's a simple solution. Instead of trying to beat the index, just buy the index. Last month, index fund pioneer Vanguard issued a research report comparing index versus managed funds and noted "persistence of performance among past [managed fund] winners is no more predictable than a flip of a coin... low-cost index funds have displayed a greater probability of outperforming higher-cost actively managed funds."

Index funds have been around since the early 1970s, but suffered from a definitive "un-cool" status for a long time. It was much more fun to think that some manager held the keys to the investment kingdom than to imagine that all you needed was a few index funds in different asset classes. And there was no massive brokerage sales force and marketing campaign blazing the trail for the stodgy index fund. Of course, the commission-based broker who was touting managed mutual funds had a great incentive -- only the expensive, loaded mutual funds would pay them.

But in the aftermath of the financial crisis, boring has become more attractive. Many investors dumped their managed funds and decided that they would prefer to start the investing year with the extra 0.80 percent in their own pockets. According to fund-tracking firm Morningstar, assets in U.S. index mutual funds and exchange-traded funds accounted for 34 percent of equity and 18 percent of fixed income funds as of year-end 2012.

The hope is to see those levels steadily rise, as do-it-yourself investors wise up or as investors who work with advisors choose fee-only or fee-based professionals who adhere to an indexing strategy.