Flip through the pages of any financial magazine, and you'll see countless ads for mutual funds. Fund companies are touting the performance of this fund and that one, implying or boldly stating that their smart managers are making big bucks for their investors. Meanwhile, unbeknownst to many, such "managed" mutual funds -- ones that feature real people picking which stocks (or bonds, or what have you) to buy and sell and when to do so -- are actually losing their appeal.

According to data from the Financial Research Corp., index funds have been gaining market share over actively managed funds in recent years. I'm not entirely surprised, for several reasons:

  • Index funds have long been recommended by us at The Motley Fool, as well as by luminaries such as Warren Buffett of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B).
  • They really are terrific for many, if not most, investors, as they permit you to invest in the entire market in one fell swoop, allowing you to avoid having to carefully pick individual stocks or funds. The largest and most popular index funds track the S&P 500 benchmark, which includes large, well-known companies like Abbott Labs (NYSE:ABT), Gannett (NYSE:GCI), and Kellogg (NYSE:K). One reason for the index's popularity is that the 500 companies it owns make up more than 75% of the U.S. stock market's total market capitalization. (Yes, those companies are that big.)
  • Index funds tend to be much cheaper than managed funds. The Vanguard S&P 500 fund (VFINX), for example, sports an expense ratio (annual fee) of just 0.18%, versus 1% or more for most managed funds.

In perspective
Still, don't think that actively managed funds are at death's door. Here are some things to keep in mind:

  • Actively managed funds still sport a commanding market share of 84% of the overall fund market, versus just 9% for index funds and 7% for exchange-traded funds (which are generally based on indexes). Believe it or not, though, that's not great news for active funds -- their share was above 90% at the turn of the millennium just a few years ago.
  • One reason given for this shift is the growing presence of fee-only financial advisors, as opposed to advisors who get a commission from managed funds they recommend. In a seekingalpha.com article, Murray Coleman notes that more than half of all advisors are paid entirely by fees, while just 20% are paid purely on commission. Fee-only advisors are free to select sensible investments like index funds without worrying about their own paychecks.
  • While index mutual funds have indeed seen their share grow, it has been a relatively gradual growth. The real growth has been among ETFs, which have seen their share rise from 1% in 2000 to 7% in 2007. They're on track to surpass the net assets of traditional index mutual funds in a year or two.

ETFs combine features of individual stocks and index funds. Read all about them and how they offer some valuable advantages over traditional mutual funds in our ETF Center.

If you'd like to read a compelling case for index funds, check out Mark Hebner's book Index Funds: The 12-Step Program for Active Investors. In it, he points at studies showing that just a handful of stock pickers beat their benchmarks. For instance, according to Hebner, the S&P 500 outperformed 97% of managers between 1994 and 2004.

And one more thing ...
Given all of the above, you might think that I'd be all into index funds, myself. But the truth is ... not so much. Yes, in my 401(k), I've invested a large chunk of my assets in a broad-market index fund. But in my personal investing, I've been sticking with a combination of individual stocks and managed mutual funds.

Why? Well, because I seek a better-than-average performance for my portfolio. A broad-market index fund will give you roughly the performance of the overall market -- which is about 10% over long periods. This is good -- because on average, most managed funds trail that. Still, there are plenty of funds with long-term, market-beating results. Those are the funds I seek. (I've found a bunch of very promising ones via our Motley Fool Champion Funds newsletter. I invite you to check it out -- a free trial includes full access to all past issues, so you can read about each recommendation.)

So it's up to you -- you can be better than average by being average, via an index fund, or you can try to beat the average via some carefully selected mutual funds or stocks.