FPA Journal - Indexing Versus Active Mutual Fund Management Indexing Versus Active Mutual Fund Management The purpose of this paper is to examine the benefits of active mutual fund management investing versus index funds. In general, we find that index funds outperform actively managed funds for most equity and all bond fund categories on both a total return and after-tax total return basis, with the exception of actively managed Small Company Equity (SCE) and International Stock (IS) funds. These results should be viewed with caution, however, as there is evidence that actively managed funds outperform the index funds during periods when the economy is either going into or out of a recession. by Rich Fortin, Ph.D., and Stuart Michelson, Ph.D. Rich Fortin, Ph.D., is a professor of finance at New Mexico State University in Las Cruces, New Mexico. He has written articles for the Journal of Financial and Quantitative Analysis; Journal of Financial Research; Journal of Investing; Journal of Financial Planning; Financial Analysts Journal; and the Journal of Small Business Finance. Stuart Michelson, Ph.D., is the Roland & Sarah George Professor of Finance at Stetson University in DeLand, Florida. He has written articles for the Journal of Business, Finance, and Accounting; Financial Services Review; Journal of Investing; Journal of Financial Planning; British Accounting Review; and the Journal of Financial Education. This paper examines the benefits of active mutual fund management versus investing in index funds. Do actively managed funds perform well enough to overcome the cost and tax disadvantages? This study is an update and extension of a prior paper by Fortin and Michelson (1999) in that a more recent and longer time period is covered, and comparisons are made across investment categories, and over time, to actual index funds rather than market indexes. An after-tax return comparison is added to the analysis. There has been a longstanding discussion over the relative benefits of active versus passive management in the mutual fund literature. On the one hand, the very fact that we have thousands of investment professionals involved in active mutual fund management suggests that there must be benefits accruing to supposedly rational investors in these funds. For example, Elton, Gruber and Blake (1996) show that their portfolio of high-alpha actively managed funds outperformed the Vanguard S&P Index fund from 1981 to 1993. Lowenstein (1997) debates whether indexing is affecting underlying stock prices. He indicates that there may be a premium for stocks that are added to the S&P 500 and that the very nature of indexing creates overvaluation of indexed stocks. Wermers (2000) finds that equity mutual funds outperform the market by 1.3 percent per year, although expenses and transaction costs reduce this benefit to essentially zero. His conclusion: "Funds pick stocks well enough to cover their costs." On the other hand, both recent and long-term evidence points to the advantages of indexing over active management. Elton, Gruber and Blake (1996) ask the relevant question: "Given that there are sufficient index funds to span most investors’ risk choices, that the index funds are available at a low cost, and that the low cost of index funds means that a combination of index funds is likely to outperform an active fund of similar risk…why select an actively managed fund?" Bogle (2000) illustrates that an index fund has a 350-basis-point advantage over the average equity mutual fund due to management expenses, brokerage costs, sales charges and tax advantages. Arnott, Berkin and Ye (2000) find that the Vanguard 500 Index fund outperforms the average equity mutual fund and the effect is amplified when taxes are considered. Malkiel (1996) notes that over the past 25 years, about 70 percent of active equity managers have been outperformed by the S&P 500 Stock Index. Gruber (1996) and Bogle (1995) also find similar results. They argue that index funds allow investors to buy securities of many different types with minimal expense and significant tax savings. Bogle (1996) states that "the case for selecting an index fund is compelling due to indexing’s inherent cost advantage." Malkiel (1995) concludes by stating that "most investors would be considerably better off by purchasing a low expense index fund than by trying to select an active fund manager who appears to possess a hot hand." 2002_Issues/jfp0902 (1 of 11)