The investment community is often ignorant or simply misinformed about passive management and index strategy performance. We correct a few common examples below.

Active managers do not fare better than indexes in bear markets.

In 2009, as they did in the bear market of 2000–2003, active managers failed to offer any advantage to investors. A large majority of actively-managed funds failed to even match their benchmark index. The table below drives the point home, showing how many stock mutual funds actually underperformed (did worse than) the stock index.

Are you paying managers for underperformance? Is a 60, 70, or 80% chance of doing worse than an index acceptable to you?

(Find more "apples to apples" comparative data at Standard & Poor's SPIVA page)

The cost savings with indexing are very significant.

Even if you don’t believe markets are efficient, here is an example of how costs effect returns. It was used by John C. Bogle (creator of the first index mutual fund) in a speech he delivered at West Point, NY on April 6, 2006.

“In 1980—2005 when the return on the stock market itself averaged 12.5 percent per year, the pre-tax return on the average mutual fund averaged just 10.0 percent.”

Not seemingly that significant, but when he translates this into dollars compounded over the 25 year period, the difference is astounding.

“In fact, $1000 invested in a simple S&P 500 Index Fund returned 12.3 percent per year during that period (the market return of 12.5 percent less costs of just 0.2 percent), growing by $17,080. By way of contrast, the average equity mutual fund’s return of 10.0 percent grew that original $1000 by just $9,820, or little more than half as much (57 percent of the total).”

Fund 5-Star Morningstar ratings do not forecast future performance.

Choosing active managers this way is a dangerous pursuit. Known as the "Five-Star Curse", active managers with stellar performance one quarter actually are often the poorer performers the next. The report below is the result of an independent study.

Click 'Next' to continue to Part 4.

[1. Why indexing?] [2. Inside an index] [3. Evidence it works] [4. Making the choice]