Since the start of the year, the average large-cap growth mutual fund has gained 2.31%, while the benchmark S&P 500 Index has increased 7.14%.
Sounds like an open-and-shut case for passive indexed investing over active management, right?
Well, maybe.
As clear cut as the passive-active debate might appear from some perspectives, it is usually measured in a way that either purposely or unwittingly favors passive management.
Let's start with that actively managed category average of large-cap growth funds.
That humble 2.31% average is made up of fund performance ranging from a 12.79% decline by the John Hancock Technical Opportunities Fund (JTCDX) to a 13.08% gain by the Equinox EquityHedge US Strategy Fund (EEHIX).
Some might argue that those extremes, including a technical opportunities fund and another with hedge in its name, is the outer limits of basic large-cap growth investing. But that's how averages are calculated, and that's also how many of the arguments are formed to challenge the merits of active management.
The point becomes clearest when one looks beyond the performance of an index and calculates index-fund performance by the same rules used to calculate active funds.
First off, any comparison to an index is already skewed because, unless there is a fund company managing money for free, there will always be an expense ratio cutting into the performance of the index being tracked.
Even though you can invest in the S&P 500 Index for the dirt-cheap cost of just 5 basis points through the $340 billion Vanguard 500 Index Admiral Fund (VFIAX), that kind of cost doesn't show up on most fund-tracking databases when comparing an active fund to an index.
“Indexed investing is getting close to free, but it's still not free,” said Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ.
According to a screen of index funds in the Morningstar database, the other end of the Vanguard fund's 5 basis points includes such high-fee index-trackers as the $259 million Rydex S&P 500 Fund (RYSYX), with an expense ratio of 2.31%, and the $495 million Federated Max-Cap Index Fund (MXCCX), with a 1.42% expense ratio.
That's a rich price to pay for indexed exposure, but such funds are attracting assets, often driven by advisers collecting sales loads.
Back to measuring index funds the same way active funds are measured, the average expense ratio of the 593 U.S. equity index funds tracked by Morningstar is a whopping 1.23%.
And, on average, those index funds lagged the S&P 500 by 2.06 percentage points annually over the past three years, and by 1.58 percentage points annually over the past five years, according to Morningstar managing director Don Phillips.
And nearly one in six of those index funds has an annual turnover rate of more than 100%.
“By this math, the same math that proves the inferiority of active managers, the average
index fund can lay claim to neither low cost nor tax efficiency,” Mr. Phillips said.
Even as a proponent of indexed investing for portfolio construction, Mr. Phillips agrees that the passive-active debate is often slanted through faulty comparisons.
“Index champions will argue, correctly, that no one buys the average
index fund and that most assets go to bigger, better index funds,” he said. “That is completely true, but the same is true for actively managed funds, where assets have long flowed to lower-cost managers with better returns, a point which index proponents seldom concede in bashing active management.”
