This debate will never end. Actively managed mutual funds are not the easiest of animals to tame. Performance relies on a series of variables that few of us could deal with on a day-to-day basis. And in their defense, I want to offer some alternative thoughts to what you might be forming as an opinion.
Not all Index Funds or their counterparts, the ETF, are created equal.
I cringe every time I hear the description of who you are as 'the average investor'. To achieve average, you must have some comparative tool by which to determine better or best, and on the flip side, worse and worst. And of course, index funds have risen to the challenge. They pose a poor comparative tool at best. In Ruth Chang's "Making Comparisons Count" she begins with the philosophical difference between incomparability and incommensurability.
They are in fact, one in the same. These terms are often used when describing different values. In truth though, it is not the value but items that bear value. The problem is, how do you compare alternatives when you need to make a choice only to find out that the comparison of these alternatives, say Fund A, B, and C are not really comparable at all. This would leave you with no tool to make the decision.
When comparing two funds, which is more often the case - more than that and the differences become diluted - investors unwittingly employ the Trichotomy Thesis. Ms. Chang offers the following when making a comparison, "the first must be better than the second, worse than it, or the items must be equally good".
She also suggests that all comparisons may have an element of bidirectionality, a feature that allows some [of the mutual fund] to be better and some of it to be worse.
Index funds and the numerous ETFs or Exchange Traded Funds that plumb every corner of the invest-able marketplace with their version of indexing are not worthy comparisons for actively managed mutual funds.
Index funds essentially are trade-less platforms in theory and adjustable ones when the index creator decides to alter the make-up of the index. This keeps the costs down and fund in a passive state. When the whole of the market goes down, the index follows in lock-step. Sometimes. And this is where you compare likes. If the index falls and your index mutual funds falls more, you do not have the index you thought you did. If it costs more than next to zero, you do not have an index fund. If it costs more than $100 to gain access, it is not worth buying. (Note on this last item: Vanguard Group will charge you a fee if your fund falls below $3,000 in value and will continue to do so until the balance has regained that threshold.)
This is how you compare likes - similar products with near-identical traits and in the case of funds, underlying investments.
Since indexes are, for lack of a better term, alike, comparing actively managed funds to them is not only foolhardy, but a waste of time. No actively managed fund is identical to any other fund. Each is a species unto itself with the only similarities that they possess to other mutual funds is where they exist. Both humans and geckos share the same planet, but the comparisons more or less end right there.
The problems facing actively managed funds come from numerous directions. And most, if not all of these problems are a result of shareholder involvement.
Consider this problem specific to actively managed funds: The market goes up and the value of the companies in your portfolio does likewise, and because you have positioned your shareholder's money well, it does better than the whole of the market or any index. Now what? Chances are, the amount of money invested in your fund will increase, coming from current investors looking to make more than they already have and from new money. And the question might seem simple enough to answer: buy more stocks. But where?
Buying more of your winners will only propel the winner's higher. Buying an undervalued stock will also have the same effect and may, in the short-term distract your new investors when the cost of buying-in seems to be higher than they anticipated. These investors will squawk when they do not get the same returns from the previous quarter, received by the investors who were there at the beginning.
The fund has a charter and that should be followed. It is an outline of the fund's strategy and if it is a growth fund, they must find undervalued growth stocks in order to continue to... grow. What happens when they have no real good prospects? They often drift and purchase a value play or simply begin to become an index. Both are lazy moves on the manager's part but it is the investor who is forcing him in those directions.
The SEC does limit the amount of cash a fund can hold. So, it must be invested. This also generates costs in trading and research. Is it bad? Not if the fund has beat its peers. It is against similar type funds that we should compare actively managed funds.
Until that is done, the comparison between actively managed funds and index funds in simply incomparable.