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Financial experts have long championed the cause of index funds. They are viewed as the low cost simple way to invest. An index fund is a mutual fund that tracks the movements of a particular index. There are index funds that track the S&P 500, Wilshire 5000, total stock market and so on. Index funds are passive investments. Index funds are a way to invest without being concerned about the performance of any one particular stock or sector. Index funds worked well in the past but lately the results have been rocky.

I will take a look at four of the Vanguard Group’s mutual funds for the sake of comparison. Two of the funds are index funds and the other two are balanced funds. They are neither the best or worst performing funds that Vanguard has to offer. They are well known funds that most investors are familiar with.

Let’s say you had invested in the Vanguard 500 Index Fund 10 years ago. You have lost 1% annually for the past 10 years. How about if you had invested in the Vanguard Total Stock Market Index Fund? You are down an average of 0.3% annually over the last 10 years. The expense ratio for these two index funds was 0.15%. You could have beat these returns by taking your money and sitting it in a drawer.

What if you had invested in the Vanguard Wellington Fund over the same time period? You would have an average annual return of over 4% for the last 10 years. The Vanguard Wellesley Income Fund would have returned over 4.5% annually. The expense ratios were 0.27% and 0.25% respectively. The average annual returns were still positive even after accounting for taxes and the great market decline of 2008.

In 1998, if you had invested in an index fund that tracked the S&P 500 index you have actually lost money. It is my expectation that this trend of poor performance by index funds will continue. Index funds thrive during great bull markets. This type of environment is unlikely going forward. The historical average return of the stock market has been roughly 10% per annum. The double digit growth that we are used to may be a thing of the past. As the economy slows, the market is expected to grow in the single digits for the foreseeable future. This places greater emphasis on the selection of assets and not just following the market as a whole. Investors will struggle to achieve anywhere close to the same returns as they did in the 90s by investing in index funds.

So, actively managed funds should produce the high returns of the 90’s? No, but actively managed funds should hold up better in a slower growth environment that requires flexibility. Actively managed funds have greater flexibility to manage risk by reducing positions and holding cash. Actively managed funds have greater latitude in purchasing assets in different categories. They also typically lose less than index funds during bear markets and thrive during moderate growth periods. I expect a solid conservatively managed balanced fund with a low expense ratio to outperform an index fund over the next few years.

Disclosure: no positions

Source: The Fall of Index Funds