2013 looks to be another year that supports the indexing strategy argument in the active vs passive investing debate. In fact, large-cap stock index funds have beaten actively-managed funds for three consecutive years. For example, if you had invested in one of the best S&P 500 Index funds at the beginning of 2011, your 3-year annualized return, as of December 13, would be around 15.00%. The average large blend stock fund returned around 13.40% for the same period (and that category includes index funds, which means the average for the actively-managed large blend funds could be significantly lower). But why do index funds beat actively-managed funds?
Why Index Funds Beat Actively-Managed Funds
Index (passively-managed) funds have a few basic advantages to their actively-managed counterparts. For one, index funds simply hold the same securities as the underlying index. Therefore, there is very little work (i.e. research, trading) required, which reduces management expenses. The average expense ratio for large-cap stock funds is around 1.25% and expenses for S&P 500 Index funds are around 0.15%, which is a 1.10% advantage.
Also, the passive element of indexing removes something called manager risk, which is the risk of receiving sub-par returns in actively-managed mutual funds due to poor management decisions. In different words, when investors try to "beat the market" they often lose to it because it is expensive and humans tend to make the wrong decisions at the wrong time.
When Actively-Managed Funds and Hedge Funds Beat Indexes
This is not to bash actively-managed funds, which includes hedge funds. By design, many portfolios such as these are structured to minimize risk and maximize returns. Therefore, actively-managed funds may consciously reduce risk exposure in rising markets by rotating assets into cash or defensive sectors as stock prices climb higher. Similarly, a portfolio manager may actively buy stocks when prices are falling. This is a kind of sell high/buy low strategy. So it is possible that some managers are not actively seeking to "beat the market" but rather obtain a reasonable return for a reasonable risk. For this reason, actively-managed funds and hedge funds may outperform the major market indices in down markets and lose to them in up markets.
However there are still those fund managers that fail to beat the market because of some combination of high expenses and poor stock selection or timing. This is why many investors turn to the wisdom of lazy portfolios.