Joseph Lisanti has an interesting article in Financial Planning magazine entitled, “Active vs. Passive: Where Money’s Flowing” which reads in part:

Many studies have shown that it’s difficult for active managers to consistently outperform their benchmark indexes. Recent data from Morningstar seems to show that investors are beginning to get that message.

At the end of August, long-term U.S. funds and exchange-traded funds held $13.85 trillion in assets.

Although slightly more than 71% of those assets were in portfolios using active management, Morningstar notes that growth of fund flows to actively managed assets was a mere 2% over the past year vs. 11% organic growth in flows to passive investment portfolios.

We know the investors under perform the very funds they invest in because they are chasing returns. The primary reason that index funds out perform most actively managed funds is because index funds, on average, have lower fees and expenses. In fact Morningstar did a study which found that lower fees and expenses was a better indicator of good future returns than Morningstar stars.

But when chasing returns, many investors move from a fund which did great last year but terrible this year into a fund which did great both last year and this year. And with the myriad of funds, you can always find a fund that has done well and beaten the markets for the past 15 years. Sure they might have had one or two 3-year patches where they under performed the markets, but they were able to win in the long run.

All things being equal, you would expect half of the actively managed funds to win a 15-year race and half of the indexes to win the race. In fact, only 17.3% of the actively managed funds win the 15 year race. But 17.3% of the funds is still a large number of funds, most of which are still running. (Fund companies often close the funds which have a 5 year patch of doing terrible and move those investors into a different fund with a manager who has done well.)

Investors mistake winning over a 15 year period as brilliance. It is not. It is statistically less significant than random chance. Most actively managed funds under perform their benchmark by their fees and expenses.

But when you have given up on your most recent actively managed fund and you are looking for a new fund, consider picking an index fund with low fees and expenses. It won’t show up in your list of the top ten funds of last year. In fact it should be around the top 40%.

Change the way you screen for mutual funds. Don’t use past performance. Use a screen for low fees and expenses instead.

Listant points out that 71% of assets are still in actively managed funds even if the movement in toward index investing. This is often not a helpful distinction. Many low cost funds are purposefully not trying to strictly follow a specific index. Do you count Vanguard Energy as actively managed? The answer is “yes.” But the expense ratio is currently 0.38%. And the turnover ratio is only 17.2%. It roughly follows the MSCI ACWI Energy Index. It is a global energy fund.

DFA (Dimensional Fund Advisors) is one of the primary advocates of passive index investing. Yet they would be the first to say that they purposefully don’t follow an index. When you purposefully follow an index you have to trade a stock as soon as possible whenever something moves in or out of an index. Those trades have costs but no greater expected return. Better to minimize costs and follow the index a little more loosely.

Even if you believe in passive index investing, you still have to decide on what to invest in over 8,000 indexes. And when investors believe in index investing they are often selected specific fund categories. Listant’s article suggests that some specific fund categories are mostly passive index investors when he writes:

In two smaller fund categories, sector equity and commodities, passive assets have come close to or eclipsed active. In sector equity, passive funds hold 46% of assets. In commodities, indexing accounts for 64% of assets.

“Index investing” and “passive investing” are poor descriptors of the proper way to do portfolio construction. Portfolios should be built along the efficient frontier of investing. You can do that without using any index or passive funds or you can do that using only index and passive funds. You can build a portfolio along the efficient frontier using just individual stocks, or you can use only mutual funds or you can use only exchange traded funds.

What is important is to understand how to build a portfolio.