Index vs. Managed Funds: Best Choice Now Could Be Both

Choosing between indexed and managed funds is really no choice at all: Investors who rely solely on one or the other these days are doomed to failure.

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The situation has been a case of pick your poison as index funds are right back where they started after a volatile 10-year journey, and managed funds in risk-adjusted real terms actually have underperformed even that low standard.

So who has been a winner in all this market malaise?

It's been investors who have used smart combinations of both to maximize returns when the market has presented opportunity and protected portfolios when danger has come.

Jeff Cox
Senior Writer
CNBC.com

"Investors need to look at this not as a choice of one or the other," says Paul Lebouef, financial consultant for Charles Schwab. "A lot of times a mix of both is perhaps the most prudent choice."

Amid the turbulence of the past years a managed fund historically would be considered the more reliable option. That's because managers have more leeway to hold safe-haven cash and take short positions in a down market than an index fund.

Index funds mimic the performance of a broad range of stocks such as the Dow Jones industrials or transportation averages, the Standard & Poor's 500 or the MSCI Commodity Index and don't have the adaptability to market changes that a managed fund provides.

Yet managed funds have won the battle only 37 percent of the time in the past three years, according to a recent report from Morningstar that emphasizes how not all managed funds are created equal and investors need to shop carefully.

"The fact that the average active fund doesn't beat an index fund doesn't necessarily mean that you shouldn't use active funds. It means you have to set the bar high," says Russ Kinnel, director of fund research at Morningstar. "It's not so much about performance but other fundamentals."

Managed funds actually have measured about even against the indexes over the past five years in total returns, but falter when adjusted for risk. Because of the wild gyrations the market has seen, investors have tended to bail out of managed funds in bad times, thus missing the upside when the market recovers.

"[P]erformance has not been enough to account for the increase in risk taken on compared with the Morningstar indexes," the firm's report said.

Yet the debate over which option is better rages on.