Interest in Indexing Intensifies
But the majority of readers say they use actively managed funds, too.
If you only followed the financial press, you might well assume that the majority of mutual fund and ETF assets are invested in index-based products. After all, with everyone from Jack Bogle to Warren Buffett recommending them, it sometimes feels like index funds are taking over the fund world.
You might be surprised to learn, however, that the majority of fund assets remain invested in actively managed funds--$10 trillion worth, according to Morningstar's latest fund-flow report for the end of March. By comparison, passively managed funds hold $4.4 trillion. But the gap is narrowing, and quickly. During the trailing 12-month period, passively managed funds saw net inflows of $486.7 billion, while actively managed funds saw net outflows of $18.8 billion.
This past week, Morningstar explored the active-passive fund divide, including a discussion of how to use both strategies in a blended portfolio. We also asked Morningstar.com readers how they're using index funds and, specifically, how much of their portfolio is invested in them.
The results were rather fascinating. Among the 62 readers providing a percentage breakdown of the strategies used in their portfolios (whether active or passive), about 20% said all or nearly all (at least 95%) is invested in index funds. Meanwhile, 15% said that little to none (5% or less) of their portfolios is in index funds. Everyone else fell somewhere in the middle, with the average overall index exposure--appropriately enough--at about half the portfolio (51% to be exact).
Some respondents also provided a breakdown of their index-fund exposure within asset classes. Among this group, the average percentage of index exposure among equity-fund holdings was 61%, while the average index exposure among fixed-income holdings was 25%.
Readers provided a variety of explanations as to why they use index funds to the extent that they do, and you can read all the comments here, including the following.
Weighing Costs and Risks
Among those choosing index funds for all or nearly all of their portfolio, low costs were often cited as the main reason, but not in all cases. Some readers said they simply don't trust active managers with their money.
GoodyearGuy wrote, "Virtually all of my portfolio is held in passively managed index funds, either at Vanguard or the federal Thrift Savings Plan. ... I am currently retired and arrived here after an education in the importance of costs and the risks associated with single stock ownership, actively managed mutual funds, and my own behavioral actions. The more I learned, the less I wanted to cede control of potentially significant decisions to an active fund manager."
Taylor Larimore, a founder of the Bogleheads.org online forum, which is devoted to index investing, summed it up this way: "Nearly all of my funds are indexed. Why? No manager risk, no style drift, no asset bloat, no fund overlap, never below-average performance, less worry, simplicity, lower-cost, better diversification (less risk), greater tax efficiency and the probability of above-average performance [as compared with actively managed funds]."
Others pointed to the fact that index funds are easy to own, including taurus, who uses index funds for all of his or her equity exposure and about one third of his or her bond exposure. "Why?" taurus wrote. "It's simple, boring, and feeds one of my key attributes--laziness."
'Suffered Too Many Ugly Surprises'
One theme that really stood out among readers' remarks was the degree to which they have been transitioning their portfolios over to index funds, especially in recent years.
For example, Bobitybob wrote, "Estimate 95% [index exposure] up from 0% about five years ago. Headed for 100%. Have been converting from individual stock and closed-end funds by using trailing stop [orders] and when dollars are needed for required minimum distributions. Am 100% invested in equities but at 73 am starting to investigate bond ETFs."
For plskmn, reading books about indexing convinced him or her to make changes. "Over the last five years, I have migrated toward both index funds and retirement," said plskmn. "I am now 100% (of equities) in index funds and I am 100% retired. The move toward index funds began about 12 years ago (2003), when the market cratered for the first time in my experience as an investor. In a panic, I read extensively and intensively and found that Bogle's Common Sense on Mutual Funds book made the most sense. Then, over time, I read more and more books by influential and thoughtful people, such as Nobel Prize-winner Daniel Kahneman's Thinking, Fast and Slow and Nate Silver's The Signal and the Noise. And, as a University of Chicago-trained psychologist and statistician, I found the arguments for indexing just plain irrefutable."
Another late-comer to index funds was JBrown, who wrote, "I once had the lion's share in managed funds but suffered too many ugly surprises, like massive year-end distributions or disastrous years following the stunning ones. Indexers usually beat managed funds, and although there have been periods when that wasn't so, it's impossible to predict those periods beforehand, or to tell which managed funds succeeded by skill rather than luck."
Among the most dramatic portfolio shifts described by readers came from Paul2025. He wrote, "I was 100% active funds through the third quarter of 2014. I used an online advisor for the last 12 years that provided the funds and allocations based on an interview. All funds were overpriced (1%-plus), but during my career I had little time to manage my retirement plan. The funds did perform well, but I could have achieved the same or better results using a combination of indexed and active funds by using Morningstar and my research. ... April 2015 bottom line: equities = 72.5% indexed and 27.5% active. Bonds/fixed income is 100% active."
In fact, several readers said they primarily use index funds for equity exposure but shy away from it for fixed-income exposure.
NWBuff wrote, "Half of my equity is in index funds. The other half is in a variety of individual dividend growth stocks. Why? Because I like the strategy and believe that it will outperform the total market over the next 10 years. All fixed income is in active open-end funds and closed-end funds as well as some individual preferred [shares]. Why? I think the total bond index fund is a horrible investment now with a very low yield given the interest-rate risk."
'Not an All or Nothing Proposition'
Other readers said they use index funds for exposure to some security types but prefer actively managed funds for exposure to others.
"In my case it really depends on the nature of the securities I am investing in," said palmreader. "When it comes to U.S. equities, I am 80% indexed. ... I try to 'beat the market' by overweighting small caps."
Among those blending both index and active funds, there were a number who said they simply like having an active manager in their corner.
For example, jhamlin said, "I have about 30% in a traditional IRA in Vanguard LifeStrategy Conservative Growth (VSCGX), which is a blend of fixed-income and equity index funds. I really prefer actively managed funds as there are some great managers out there. I like Don Yacktman, Judy Vale of Neuberger Berman Genesis (NBGNX) and also Meaghan Walsh of Invesco Dividend Income (FSTIX). Another favorite is the team at Franklin Mutual Global Discovery (TEDIX) and the team at Artisan Small Cap (ARTSX). I believe that good managers will always best an index, so I buy the manager not the fund. I have survived the 2008 crash and my funds have done well over the years. I just buy what has worked for me."
Lionsgate put it this way: "We hold active and passive funds throughout our combined investment accounts, with the slight edge given to active management, about 55% to 45%. This is not due to a predetermined investment philosophy. The mix evolved over time because, given all our choices, taking a balanced approach settled the internal debate of which way is best. It's not an all or nothing proposition."
Retiredgary described how he mixes index funds with his own stock or fund picks. "About 60% of our equity holdings are in index funds with the rest in individual stocks or managed funds," he said. "We like index funds for the usual reasons. However, we also like buying stocks of good companies when their prices indicate a good value and like using managed funds in areas such as aggressive growth, biotech, and small-cap international, where the knowledge and ability of a good manager seem worth paying for."
Another reader, Racqueteer, said that each strategy has its strong suit, depending on market conditions.
The commenter wrote, "I mostly prefer actively managed funds, sometimes because I feel the assets lend themselves more to a managed approach, sometimes for volatility reasons. Indexes have the advantage when the market is running [strong], I feel, because they are always fully invested. Costs, too, tend to be more favorable with indexes."
Finally there was jaterpening, who said that holding on to some active funds just makes things a little more interesting.
"Over 95% in index funds, or funds of index funds," jaterpening wrote. "I still hold, and occasionally purchase, actively managed funds. It is, I suppose, a vestigial idea left over from the days before indexing was well known or accepted. I know that indexing is the clear winner long term, but there is something about researching and choosing actively managed funds that is somewhat more interesting. It also allows me to capture and overweight certain segments of the market. But unquestionably, indexing is the simplest, most effective way to capture the risk and return of entire asset classes, and the smartest way to build a sound portfolio."
'I Think I Can Beat the S&P 500'
Of course, there also was a vocal minority of readers who said they don't own any index funds at all.
"Call me delusional if you want, but I think I can beat the S&P 500 stock index with the same or less volatility by picking my own mix of funds," said mysticaltyger. "All of the funds I own in my retirement accounts are Morningstar Medalists except for one that's unrated (but still has above-average performance and below-average expenses for its category). It helps that I have some solid choices in my workplace retirement plan that wouldn't be available to me as a retail investor (or would be, but at the cost of a load or higher expense ratio--or both)."
For jomil, income is the issue.
"None of my portfolio is in index funds now because their yield wasn't meeting my spending needs," the commenter wrote.
But even among those with no index exposure at all, some said it is something they would consider.
"My open-end fund exposures in both taxable and deferred accounts are all active funds, though with very cheap expense ratios," said rforno. "I'm not opposed to throwing a slug of cash into an equity index product, but at the moment I don't see a need to do that in my case."
Some comments have been edited for clarity and brevity.
Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.