Are you among those who believe that index funds/ETFs have proven themselves to be better performers than managed funds?

Like any in debate in which actual factual data can be examined to either help prove or disprove something, in the following article, extensive comparative performance results will be presented that will be hard for people who believe in the presumed inferiority of managed funds to explain. In fact, the results presented below, upon careful consideration, should be regarded as perhaps game-changing to what many investors have come to believe. So let's jump right into this data.

If index funds are superior performers to managed funds, the average mutual fund which includes all diversified funds should, when examined over a long period, obviously tend to do more poorly performance-wise. So is this true?

While I can't examine all index funds, I selected two of the most popular ones, the Vanguard Total Stock Market Index (VTSMX) which represents the entire US stock market, and the Vanguard Total International Stock Index (VGTSX) which represents the entire rest of the world excluding US stocks. In fact, most other broad stock market index funds as well as ETFs should achieve just about the same performance results, less very minor difference in expense ratios.

On the other hand, there is available published data on the average performance of all diversified US stock funds as well as all International (non-US) stock funds. This data is published monthly in the Wall Street Journal.

By comparing the returns of each of these two index funds with the returns of the average US and International fund, one can determine, over the course of any given year, which did better, the index or the average of all similar types of funds.

To prove the superiority of index funds, one would expect to see a pattern of better performance vs. the average fund of its comparable type.

But, to be convincing, such comparisons, would need to encompass a long stretch of time. This is because while one measure might be superior for a relatively short number of years, the other might be superior over another stretch. With that in mind, examine the following:

Comparing Yearly Broad US Stock Market Index Performance with That of Average US Diversified Fund

Indeed, each year between 2011 and 2016, the US stock index fund did consistently better than the average US stock fund. The average difference was +2.7%. Given this wide degree of outperformance for the index, it starts to become understandable why many investors are now convinced that index funds are clearly superior in performance to the average fund, many of which are managed funds, not passive indexes.

But data from the past six years alone are not sufficient to conclude that an index fund will almost always come out ahead over other time periods. If we examine the same data going further back to 2000, we find a somewhat different pattern, with the average fund actually coming out a little ahead of the index, although on an irregular basis depending on the specific year. In this period from 2000 to 2010, encompassing 11 years, the index fund comes out behind the average fund by an average of -0.8% per year. The following table shows the comparisons:

What this appears to suggest is that outperformance by a broad index may be cyclical, that is, the index may excel over some years, or even over a number of years running, but one can hardly assume that the index won't underperform the average return of diversified funds for a number of years either.

Nevertheless, if one averages the differences over the entire 17 year period, the index fund still comes out ahead of the average fund by +0.5%. For advocates of index funds, this is just what they would expect. However, the relatively small margin of difference tells us that the result should be considered as entirely predictable, considering that the average fund charges quite a bit more than the index, accounting for all of the difference and even more. So, no real surprise here yet.

How much more does the average fund charge? According to a recent Morningstar article, the average most apparent cost, that is, the expense ratio, across all funds was about 1.2% in 2014, although higher in earlier years. The most recent cost of VTSMX is less than 0.2%. Thus, one is looking, at a very minimum, at about a 1% difference. Additionally, there likely will be another hidden cost within managed funds, namely the trading commissions whenever a fund manager buys or sells. Also excluded are instances if a managed fund charges an initial cost (load) when you buy or sell that fund.

Therefore, were it not for these higher costs subtracted from the average fund's pre-expense performance, the average fund might have actually beaten the index by a minimum of approximately 0.5% per year. In other words, it appears that, on average, the average mutual fund would clearly be as good or better in picking stocks than a broad market index except for the extra drag caused by the higher expenses. This could, incidentally, help to dispel the notion that the average fund manager, in spite of his presumed expertise, is actually a worse selector of stocks than those in the passive index.

Unfortunately though, these expenses do exist for the "average" fund, and at least for the above comparisons, we must declare the index fund the winner. I also found similar results when comparing the performance of the Vanguard Total International Stock Index (VGTSX) with that of the average International stock fund, with some small variations. (These results will be reported at the end of this article.)

Now that the above data appear to have made a pretty convincing case for index funds giving better end results than managed funds, I will now present data that can lead to a very different conclusion.

How can this be? If one can identify managed mutual funds whose expense ratios (and possibly, other costs) are significantly less than the above average 1.2%, they, as shown by the above 17 years worth of data, should have a good chance of beating the passively managed broad indexes. So, for example, if the above data are indeed representative, by merely choosing managed funds that chop this average expense ratio in half (to 0.60), such funds, on average, should be able to beat the index, erasing the average 0.5 deficit.

These days such lower cost managed funds are not that hard to find. At least several fund companies have good lineups of funds with a much lower than average expense ratio. For example, Vanguard is well known not only for its low-cost index funds and ETFs, but for its nearly as low cost managed funds.

So how much better can low cost managed funds do than the above two index funds? While obviously not all low cost managed funds will do better than the index, Vanguard funds have a long-standing reputation for being excellent choices.

To answer this question, I searched the complete lineup of Vanguard managed funds to find all those that have been around since at least the start of 2000. There were 20 such funds. (Note: Just one generally available stock fund shut down over this period, which if excluded due to poor performance, might make the results for the remaining funds look better. However, the shutdown was due to other factors, not poor performance.) I then researched the yearly average performance of each of these funds and compared each to the yearly average performance of either VTSMX or VGTSX, depending on whether the particular fund's main focus was domestic or international stocks. The following table shows the results:

Comparing Average Yearly Performance Returns for Vanguard Managed Funds Vs. Those of US or International Index Funds

Now, here are the same results for the above two Vanguard index funds

As you can see in the last column of the bigger table, 17 out of the 20 managed funds delivered better 1 year average performance than the appropriate broad market index. The average per year better performance was 2.76%. You can observe that the 20 funds included three funds that were not diversified across the broad market, so-called sector funds; these funds proved to have the best average yearly performance of the 20. Therefore, to beat the indexes to this degree, one would have needed to select not just the typical diversified types of funds, but also included some other relatively low cost funds within the Vanguard lineup that would not at all closely reflect the entire market as the indexes did.

Just in case you're wondering whether the above results would remain valid if one merely considered the average annualized returns over the entire 17 year period instead of averaging each fund's one year returns over 17 yearly periods, data shows that the answer is emphatically yes. According to that analysis, the entire 20 funds averaged an annual return of 7.16%, beating the "buy and hold" annualized returns of VTSMX at 4.92% and VGTSX at 2.72%. The analysis of 20 funds over 17 separate time periods involved 340 separate data points, highly unlikely to introduce chance into the result vs. analyzing just 20 data points when using just the 17 year total return. And, additionally, while most investors undoubtedly don't hold most of their funds for an uninterrupted 17 years, most will eventually drop underperforming managed funds out of their portfolio, likely making the one-year start and stop points more realistic.

Comparing Yearly Broad International Stock Market Index Performance with That of Average International Fund

Here are the International stock fund results mentioned above:

The table shows that over the last 6 calendar years, it was the index fund that has underperformed the average International stock fund on average by 0.6% per year.

However, as shown below, for the 11 yearly periods between 2000 and 2010, the average International fund did very frequently underperform the index fund; the average yearly shortfall was 1.9%.

Over the entire 17 yearly periods, the International index fund came out beating the average International fund by 1.0%. However, as with the US focused funds above, the difference was not a surprise considering that the average fund charges quite a bit more than the index. (According to data from Morningstar, the average International fund charges an expense ratio that is about 0.2 more than domestic funds, or about 1.4% in 2014, and even higher in earlier years).

Therefore, a well-established, managed, internationally focused fund which charges considerably less than 1.4%, such as the five such funds included in the 20 listed above, should have a reasonable chance to come out as well as, or ahead of, the International index fund, assuming the above results are at all representative of many years of comparisons. Specifically, the five averaged a yearly average return of 8.8% vs. the yearly average of 5.1% for the index fund.