If you follow the money, it's clear that investor enthusiasm for index funds and other passive investments continues to grow. But should you join the herd?
Many financial advisors prefer to focus on the performance outcomes of their clients' investments instead of the strategy used to get there.
"We tell clients that we're indifferent to whether it's passive or active, from a philosophical standpoint," said certified financial planner Shon Anderson, president and chief wealth strategist at Anderson Financial Strategies. "Whatever has the best performance in that asset class is what we'll put in a portfolio."
Whether all the new money flowing into passive strategies follows the same philosophy is hard to know. But data from research firm Morningstar show that whatever the reasons may be — lower costs, tax efficiency, better performance — passive investments continue to gain new money as traditional actively managed mutual funds watch money leave their coffers.
Year to date through August, active mutual funds saw $153 billion in outflows. On the other hand, index funds — which are passively managed — pulled in nearly $145 billion in new money during the same time. Additionally, about $138 billion flowed into passive exchange-traded funds.
Nevertheless, actively managed funds still hold significantly more assets than passive investments: $9.7 trillion vs. $2.8 trillion in index funds, and $2.4 trillion in standard ETFs. (Actively managed ETFs — which in simple terms are a combination of indexing and active management — held about $27 billion in assets at the end of August.)
But before deciding where your money should be, it's important to understand the pros and cons of both active and passive approaches.
Passively managed funds include index funds and, in general, ETFs. Index funds, as their name implies, mimic a particular market index, both with holdings and exposure to each holding. Most ETFs do the same thing, but trade throughout the day like stocks.
This means that the fund's or ETF's performance will also track the performance of the index. If the index goes up, the funds and ETFs tracking it also rise. But it also means if the index goes down, so do the funds.
"With indexing, you're accepting returns that are whatever the index does," Anderson said.
In actively managed funds, professional stock pickers use sophisticated research and human judgment to choose which investments to include in the fund. The fund's performance is measured against a benchmark, and that's where the majority of actively managed funds fail.
Data from Morningstar show that year-to-date through mid-September, a full two-thirds — 66.6 percent — of roughly 11,000 actively managed mutual funds have fallen short of their benchmarks.
Broken down further, 72 percent of stock fund managers have missed the mark; 54 percent of bond fund managers have. The long-term doesn't look much better: Over the last decade, roughly 70 percent of all mutual funds underperformed their benchmark.
"When you hear those statistics, it overlooks the remainder that have beat their benchmark," Anderson pointed out. "If you have processes in place that identify and track those active managers … then you can [improve performance] in your clients' portfolios by using them."
There are also financial advisors who are active investment managers for their clients.
Rob Lutts is among them. His firm, Cabot Wealth Management, has a minimum account size of $1 million. While clients pay an average 1 percent of assets managed, that cost includes services in other areas, such as taxes, retirement planning, insurance and estate planning. (The firm also takes no commissions on any investment product.)
"It's hard to justify a 1 percent fee on just investment management," said Lutts, Cabot's president and chief investment officer. "If I were only doing investment management, my fees would be lower."
Nevertheless, in the mutual fund world, the average expense ratio for actively managed stock funds stands at 1.28 percent; for actively managed bond funds, it is 0.97 percent.
By comparison, equity index funds come with an average expense ratio of 0.64 percent and bond index funds' expense ratio is 0.28 percent. Passive ETFs run even cheaper: 0.47 percent for equity ETFs and 0.27 percent for bond ETFs.
On top of the sometimes higher fees, capital gains are distributed to a mutual fund's shareholders, regardless of the fund's performance.
CFP Ben Gurwitz said that in 2008, in the midst of the financial crisis, he had clients who saw a 40 percent drop in the value of their taxable accounts. On top of that, they owed capital gains taxes because the money was in actively managed funds that sold off investments showing gains.
"Every time an active manager sells inside a portfolio, it carries out to the investors," said Gurwitz, a wealth manager and chief investment officer for Financial Life Advisors.
Meanwhile, because of the structure of index funds and ETFs, capital gains are essentially nonexistent, which makes them attractive from a taxation standpoint.
Gurwitz said his firm uses index funds because of both their slight outperformance over active funds and their tax efficiency.
"The benefits of compound interest growing unmolested by taxes in retirement accounts is well known … but index investing can do a similar thing in taxable accounts," Gurwitz said.
Whether the move toward passive investing will continue is open to debate. Some pros think a bear market will bring about renewed love for active managers because that's where they can prove their worth, by moving assets around instead of only mimicking a losing index.
In the meantime, Anderson Financial Strategies' Anderson and other advisors who still value active management caution investors that trying to pick successful actively managed funds on their own is a big job.
"If you have the ability and the commitment to track actively managed funds, you may be able to outperform," Anderson said. "But if you [don't] have the time or expertise to identify and track those investments, indexing is the way to go."
— By Sarah O'Brien, special to CNBC.com