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Index Funds Are Hard to Beat

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An eye-opening new study from Standard & Poor's reveals that the majority of managed funds fail to outperform simple index funds. That's right -- funds run by actual human beings still can't beat a copycat strategy of matching a broad index's holdings.

Over the five years ending in mid-2008, the S&P 500 beat 69% of managed large-cap funds. The S&P mid-cap index, small-cap index, and global index also outperformed the majority of their managed counterparts.

In short, Fools, if your actively managed funds aren't beating the market, opting for index funds instead might still secure solid performance for your portfolio. There's no shortage of indexes to choose from: 

  • Invest in the S&P 500, and you'll instantly be a part-owner of companies from AutoZone (NYSE: AZO  ) to Coach (NYSE: COH  ) to Xerox.
  • The S&P MidCap 400 gives you exposure to a much smaller group of companies, including Martin Marietta (NYSE: MLM  ) , Ross Stores (Nasdaq: ROST  ) , and Western Digital (NYSE: WDC  ) .
  • Various international indexes, such as the MSCI EAFE Index, will include shares of foreign companies big and small, such as Nokia (NYSE: NOK  ) and Diageo (NYSE: DEO  ) .

Beyond its headline results, I found a couple of other intriguing insights hidden in the study's findings.

Survivorship bias
Suppose you look back to 2004, and track the following five years' performance of all the mutual funds operating then. By 2009, some of those funds -- the worst performers, most likely, won't be around anymore. If you ignore their returns and focus solely on the surviving funds, your results may skew more positively than they should.

With this "survivorship bias" factored in, I was surprised by just how many funds merged or closed shop during the study's duration. Over five years, only 64% of large-cap funds survived. Even over just three years, one out of every five large-cap funds disappeared.

Actual returns
It's easy to say that a fund beat or lagged the index -- but how much of a difference did it actually report? Over the study's five-year period, the S&P 500 averaged a 7.58% return, while large-cap funds averaged 7.19% on an equal-weight basis. The difference is meaningful, but not huge. With $25,000 invested for 25 years at those rates, you'd end up with $142,000 for the large caps and $155,000 for the index.

That $13,000 gap seems even smaller when compared to the difference made by the various funds' fees. Index funds tend to charge very low fees, as little as 0.2% or less per year, while managed funds typically charge between 1% and 2%. The difference -- 0.8% to 1.8% -- is quite a bit bigger than the amount by which index funds beat active funds. In short, if the managed funds weren't charging such high fees, they might actually stand a decent chance of outperforming the indexes! Remember, Fools, fees matter -- in actively managed and index funds alike.

Aim for average -- or better
To make investing as easy as possible, simply plunk your money into index funds and forget about it. There are far worse strategies to pursue. But if you want to aim for better-than-average returns, consider investing in carefully chosen individual stocks, or in managed mutual funds that can beat those averages. They're out there -- all you have to do is find them.

Need a little help? Check out our Motley Fool Champion Funds newsletter with a free 30-day trial.

Learn more about index investing:

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Diageo is a Motley Fool Income Investor selection. Nokia is a Motley Fool Inside Value pick. Coach is a Motley Fool Stock Advisor recommendation. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.

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