[Originally published 2/3/2014]
By MP Dunleavey
A groundbreaking study by Rick Ferri of Portfolio Solutions
and Alex Benke of Betterment sheds new light on why index
portfolios beat active investing.
The debate over active and passive investment strategies, now
more than 60 years old, shows no signs of ebbing.
If anything, this controversy has spawned a cottage industry,
including dedicated blogs, sparring matches, and even a yearly
scorecard-Standard & Poor's Indices Versus Active, or
Despite the volume of data and opinion fueling each side, the
bottom line remains that index funds predominantly outperform
comparable active funds. But until now the industry hasn't fully
explored the following question:
Given that index funds tend to outperform active ones,
will an all index-fund portfolio likewise outperform a portfolio
of comparable actively managed funds?
Now, Alex Benke, CFP® and product manager at Betterment, Rick
Ferri, CFA, founder of Portfolio Solutions, have tackled just that
issue in an innovative new study.
Alex Benke, left, and Rick Ferri, discuss their research on
a Dow Jones video last July.
In their analysis, originally released as a white paper in June
2013 and newly published this month in the Journal of Indexes,
Benke and Ferri pitted all index-fund portfolios against portfolios
holding comparable actively managed funds under six different
conditions. The results demonstrate that "a diversified portfolio
holding only index funds in all asset classes is difficult to beat
in the short-term and becomes more difficult to beat over time,"
the authors wrote.
The study documents yet another significant advantage of
investing in index funds-and it unearthed several other insights
that can serve as guiding principles for all investors.
Index funds perform better together
One of the first compelling new insights to emerge was that an
all index portfolio tends to perform better than just the sum of
its parts, compared to an active portfolio.
This surprising result emerged from the following test: The
authors created a basic 60-40 portfolio with three of the most
commonly held asset classes: 40% in a broad U.S. equity fund, 20%
in a broad international equity fund, and 40% in a U.S.
investment-grade bond fund.
They then compared this all-index portfolio to 5,000 portfolios
of randomly selected, comparable actively managed funds over a
16-year period (1997 to 2012).
You can read details on the
experimental methodology below
, or in
the white paper here
The basic result was eye-opening, but not unexpected: The all
index-fund portfolio outperformed the active ones 82.9% of the time
during the 16-year period. The median annual shortfall of the
losing active portfolios was -1.25%, and of those that
outperformed, the median outperformance was 0.52%. (The authors
note that while outperformance of actively managed portfolios is
clearly possible, it wasn't robust enough to make up for the
But what really stood out was the combined performance of the
index funds. When the authors examined the individual performance
of each index fund in the portfolio, they all tended to outperform
comparable active funds-but the result was higher when taking the
three index funds together.
Table 1. Estimated winning percentage of an all index
fund portfolio over 16 years (1997-2012)
VTSMX (US equity: 40%)
VGTSX (Int'l equity: 20%)
VBMFX (US bonds: 40%)
Scenario 1 Results
As the authors wrote, "index funds, when combined together in a
portfolio, have a higher probability of outperforming actively
managed funds than they do individually," a phenomenon that was
persistent in every scenario they tested. While the weighted
outperformance of the individual funds was 79.9%, the
outperformance of the index portfolio as a whole was 82.9%.
Indexing long-term boosts returns
Next, the authors looked at the difference in the probability of
an all index-fund portfolio outperforming an all-active portfolio
in the short-term versus the long-term. The authors tested the same
basic three-fund index portfolio as above, in three five-year
periods ranging from 1998 to 2012, as well as that entire 15-year
Again, the results weren't unexpected (as buy-and-hold investors
could guess). In the long-term scenario, the outperformance of the
all-index portfolio was higher than the average of each of the
three five-year periods tested.
But here another striking phenomena emerged: The outperformance
average for the three five-year time periods was 76.5%; but if you
held onto the index-fund portfolio for 15 years, it outperformed a
comparable active portfolio 83.4% of the time-a significant
Reflecting real-world behavior
Needless to say, few investors actually stick to simple
three-fund portfolios. To give their research more real-world
validity, Ferri and Benke then added more asset classes to create
equally weighted five-fund and 10-fund index portfolios, which they
then tested against portfolios of comparable actively managed funds
(also equally weighted).
Table 2. Index fund portfolio win rates and percentages
by the number of funds 2003-2012
Run 1: Three-fund portfolio
Run 2: Five-fund portfolio
Run 3: 10-fund portfolio
But there was an unexpected twist to the results: It turns out
that adding additional asset classes to the active portfolio
actually reduced both its potential for loss, and its upside
potential. The median win became smaller, and the median loss
became smaller. Thus it seems that the more diversification there
is in actively managed fund portfolios, the less variation there is
relative to an all index fund portfolio.
How many funds do you need?
The real trouble for investors seems to lie in the assumption
that more funds equals better performance. The authors note that
many investors often hold more than one actively managed fund in
each asset class (e.g. an investor might have a couple of U.S.
equity funds to diversify fund companies or managers) to hedge
Is this a good idea?
No. In fact, as more active funds are added per asset class,
this study found, the more an all index-fund portfolio is likely to
outperform an all actively managed portfolio.
In other words: Multiple active funds within each asset class
skunk performance. Adding funds to increase overall diversification
helps the performance of an all index fund portfolio, as above, but
when active investors add funds within asset classes it actually
decreases an all-active fund portfolio's performance.
Three guiding principles
Thus, Ferri's and Benke's research demonstrated the indexing
advantage from the fund level to the portfolio level. It also
surfaced three powerful insights that can serve to guide investors
in their real-life choices.
- An all index portfolio is greater than the sum of its parts.
Index funds, when combined together in a portfolio, have a higher
probability of outperforming actively managed funds than they do
- An all-index portfolio performs best over longer time
periods: an all-index portfolio held for 15 years significantly
outperformed the average of three five-year periods.
- Adding more funds within an asset class in an actively
managed fund portfolio typically results in even worse
underperformance relative to an all index-fund portfolio.
But of course, the merits of these conclusions hinge on the
integrity of the methodology, which sought to level the playing
field as much as possible between active and index funds.
In devising research conditions to deliver results that would be
most useful for real investors, Ferri and Benke sought to imitate
certain real-life conditions that investors face.
- They only used funds that were actually available to
investors during the time periods tested (avoiding so-called
- They used a common 60-40 equity asset allocation for both
index and active test portfolios.
- The three-, five- and 10-fund index portfolios tested were
based on the most common passive (mostly) Vanguard funds.
The authors also made an effort to level the playing field
between index and active funds in order to focus as much as
possible on actual performance.
- They excluded sales loads and redemption fees from active
fund performance, because the fees have a negative impact on
- They selected the index fund share class with the highest
expense ratio when two or more share classes existed.
- The authors did not rebalance the portfolios in any of the
tests; and they analyzed pre-tax performance even though index
funds tend to have better tax efficiency.
How active funds were chosen
The authors used a random portfolio selection process to run
5,000 simulated trials of available actively managed fund
portfolios, except in one experimental condition. In one of the
test conditions, the authors applied a low-fee filter to the active
funds, because so much research has documented that fees are the
leading cause of underperformance.
But when they ran simulated trials only using funds that are in
the lowest 50% in terms of their expense ratios (and excluding
front-end and deferred load funds), the authors note:
A common belief in the investment community is
that low-fee actively managed fund portfolios have a
meaningfully higher chance for outperforming an all
index fund portfolio. We find no evidence to support
The authors conclude that future research could deepen this
exploration by taking into account a longer time horizon (in this
study, the authors were limited to a 16-year period because many
index funds didn't exist prior to 1997). And they recommend
applying other filters to better hunt for alpha among active
For example, new data shows that active managers who are truly
active outperform those who are less active but still charge high
management fees for their services. Perhaps this or other
factors-e.g. funds with higher ratings or bigger AUM, the fund
managers' ages or education-could become other filters that might
shed light on active funds' top performance.
In the mean time, the jury's no longer out: An all index-fund
portfolio statistically wins.
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