Indexing is still on top, but active management can play a role, too

There's no denying that indexing is on a tear. Over the last 10 years, investors have plowed $1.57 trillion into index funds but have yanked $1.3 trillion out of active funds, according to research firm Morningstar. And the trend shows no signs of abating.

"We've seen a big shift since the financial crisis, and with bond yields being as low as they have been, people are increasingly sensitive to low costs," said Daniel Wallick, principal and investment strategist with Vanguard's Investment Strategy Group.

Low costs, predictability and the overwhelming positive performance of the broad indexes have swayed many investors to indexing's corner.

"You will never underperform the index, but of course, you'll never outperform, either," said Janet Brown, president and CEO of FundX Investment Group and publisher of the NoLoad FundX newsletter.

But is indexing the panacea for all investors all the time?

The last few years have indeed been kind to indexers. According to the Standard & Poor's Index vs. Active (SPIVA) Scorecard, a semi-annual report that compares actively managed funds to their benchmarks, active funds are lagging. According to the data, just 7.8 percent of large-cap funds, 5.6 percent of mid-cap funds and 6.8 percent of small-cap managers trail their benchmarks over the 15-year period. The numbers tell a similar story in the short- and intermediate-term, as well.

"We've been in a large-cap growth market where it's been very difficult to outperform the ," Brown said.

Index funds have a couple of things going for them that make it hard for active managers to compete. First, they tend to have low fees. The average actively managed fund has an expense ratio that's almost twice as high as the typical index fund.

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Then, there's stock picking. Even the staunchest index adherents believe that active managers can get lucky now and then, but it's not usually a skill that can be sustained. A recent study by Hendrik Bessembinder, a professor in Arizona State University's business school, found that since 1926, the entire net gain of the U.S. stock market can be attributed to just 4 percent of companies. The remainder of the stocks either had returns in line with Treasury bills or worse.

What that means, contends Paul Merriman, a retired financial planner, is that it's really hard to isolate the winners. Merriman is now the founder of the Merriman Financial Education Center in Seattle, which aims to increase financial literacy.

"There's no evidence that active management is going to raise your return," he said. "That's no different than having half your money in T-bills."

So what's behind the outperformance of indexing? All else being equal, fees go a long way toward helping to boost performance, and index funds have an edge there. A fund company can easily keep fees down when there aren't portfolio managers or legions of analysts on the payroll.

"It's not active vs. passive," said certified financial planner John Fattibene, director of financial planning with Harvest Financial Group. "It's high cost vs. low cost."

Harvest works with small businesses on designing and managing their 401(k) plans. Since more attention has been focused on the role of high fees in plans in recent years, Fattibene's clients have emphasized index funds.

"If you want to drive down fees to participants, indexing gives you a great start on that," he said. "It's the easiest way to drive down your cost."

Fees have come down dramatically for the most popular index funds, such as those that follow the Standard & Poor's 500. At Vanguard, Admiral shares of its flagship Vanguard Standard & Poor's 500 fund are just 4 basis points. Though the fund has a $10,000 minimum, it is widely available to 401(k) participants who don't invest that much. Schwab, BlackRock and Fidelity also offer funds charging similarly skinny fees.

"We're delighted by the price war among index funds," Fattibene added.

That's not to say that active management is a non-starter. It has a special place even at Vanguard, the temple of indexing. About a quarter of the assets the firm manages are invested in active strategies.

"For active management to work, three things have to be present: talent, cost and patience," said Wallick of Vanguard.

Bank of America Merrill Lynch (BAML) recently released research that pinpoints times when active managers can thrive. Examining U.S. fund returns since 1991, BAML found that when the stocks in the S&P 500 were less correlated (that is, they didn't move in lockstep) and also when there was a wider disparity between the best and worst performing stocks, fund returns were better.

Brown of FundX believes it's possible to pick active managers that can outperform, but it has less to do with skill than trend following.

"Much of what causes managers to outperform is the asset allocation and sector positioning," she said. "The managers that perform well have a very finite period of outperformance."

Because large-cap growth funds have had such a strong period of outperformance in the last few years, investors might think carefully about allocating too much more to those stocks going forward.

"I'm concerned that many passive investors don't fully appreciate the risk they're taking," Brown said.

But on average, active management hasn't shielded investors from the downside. In 2008, a year when the S&P 500 was down a whopping 37 percent, the average large-cap blend fund fell 37.4 percent. The Russell 2000, an index of small-cap stocks, was down 34.8 percent that year, while the average small-cap blend fund was off by 36.6 percent.

"These are the people who are supposed to protect people from these kinds of markets," said Merriman of the Merriman Financial Education Center. "They didn't."

The debate about whether indexing or active management is better may never get settled by the professionals. But as current trends indicate, ordinary investors certainly have made up their minds.

— By Ilana Polyak, special to CNBC.com