Actively managed vs. Index mutual funds

Many of you wonder: Would I be better investing into Actively managed over Index mutual funds?

If you do your research on the Internet you can find contradictory statements. Some vote for actively managed while others for index funds.

For example,the BusinessWeek article by Tara Kalwarski states that 66% of active managers outperformed the US stock market in 10 years ended December 31, 2008. From another prospective you might hear many pundits saying that regular investor would be rather investing in index funds.

Here are the issues with the proponents of active managed funds for regular investor.

In the above article Tara Kalwarski quotes Francis M. Kinniry Jr from Vanguard stating that investing into index funds will underperform active managed funds. However in one of Francis Kinniry's research papers it states that over long period of time: 'we expect active management strategies to trail appropriate benchmarks by the margin of their expenses'.

Let's say, some active manager will beat corresponding index over some time period. But how to know beforehand whether certain manager will actually beat index. See a very interesting study from Barclay Global Investors. They claim that only 12.2% of active managers beat S&P 500 3 years in the row, 13.9% beat S&P 600 index, and 19.4% beat MSCI Emerging Markets index (data is from 1993 to 2008).

I think that average investor would be better to invest in index funds properly diversifying among various asset classes and he/she will be totally fine in the long run. Yes, an investor can invest some money into active managed funds, but he/she should not have any illusion. There are more chances to underperform the market when investing into actively managed funds than beat it.

If an investor decides to invest in actively managed funds he/she should do it in tax sheltered accounts such as 401K and IRA. Otherwise expenses taken for taxes will increase chances to underperform market. See this New York Times article.

Also an investor should not have any illusions that if an active manager outperforms the market it is sustainable. As I mentioned earlier on average there are less than 20% chances that an active manager will outperform market 3 years in the row.

Sure, an average investor can take chances by picking some active manager hoping that the manager beats the market. And maybe that investor will be lucky. But overall I think an average investor would be better off when buying index funds!