Recipe For Success

Based on research by Alan Crane and Kevin Crotty  

• Index funds are considered passive because they try to match a predetermined set of stocks rather than beat the market.
• The popularity of index funds has exploded over the past 20 years, creating a rich subject for scholars and commentators.
• Risk-averse investors should lean toward index funds. In fact, a randomly chosen index fund performs better than a randomly chosen active fund after accounting for risk.

It’s easy to assume that investing, like cooking, requires skill to get the right mix of ingredients. But that’s not the case with index funds. Effort goes into building them, but these ready-made investments need minimal intervention. Yet the outcomes are appetizing indeed.

In the past few decades, use of index funds has exploded. So have media coverage and advertisements questioning if they can truly compete with active funds. A recent study by Alan Crane and Kevin Crotty, professors at Rice Business, provides a resounding “yes.” These humble investment recipes, it turns out, are richer than they might seem.

Index funds track benchmark stock indexes, from the familiar Dow Jones Industrial Average to the widely followed Standard & Poor’s 500. Like viewers following a cooking show, index fund managers buy stocks in the same companies and same proportions as those listed in a stock index. The best-known indices are traditionally based on the size of the companies.

The idea is that the index fund’s returns will match those of its model. An S&P 500 index fund, for example, includes stocks in the same 500 major companies included in the Standard & Poor index, ranging from Apple to Whole Foods.

Index funds are part of the broad range of investment products called mutual funds. Like cooks making a stew, mutual fund managers add shares of various stocks into one single concoction, inviting investors to buy portions of the whole mixture.

While some mutual funds are active, meaning professional managers regularly buy and sell their assets, index funds are passive. Their managers theoretically just need to keep an eye on any changes in the index they're copying. Not surprisingly, active index funds tend to charge more than passive ones.

Curiously, not all index funds perform at the same level. So what should that mean for investors? To study these variations and their implications, Crane and Crotty expanded on past research about skill and index fund management, analyzing the full cross section of funds.

This wasn’t possible to do until fairly recently: there simply weren't enough index funds to study. The first index fund, which tracked the S&P 500, was developed by Vanguard in the 1970s. To do their research, the Rice Business scholars looked at performance information for both index and active funds, starting their sample in 1995 with 29 index funds. The sample expanded to include a total of 240 index funds, all at least two years old with at least $5 million in assets, mostly invested in common stocks. They also analyzed 1,913 actively managed funds.

Using several statistical models, Crane and Cotty found that outperformance in index-fund returns was greater than it would be by chance. The discovery suggests that passive funds, although they require little skill to run, have almost as much upside as active funds.

In fact, the professors found, the best index funds perform surprisingly closely to the best active funds, but at a lower cost to the investor. The worst active funds perform far worse than the worst index funds — even before management fees.

The findings topple the conventional wisdom that only actively managed funds stand a chance of beating the market. While active-fund managers often measure their success against that of passive funds, the data show investors who are risk averse would do better to choose passive funds over more expensive active ones.

More adventurous investors, of course, will always be tempted by what's cooking in actively managed funds. But overall, investing in plain index funds is as good a meal at a lower price.

Alan D. Crane is an associate professor of finance at the Jones Graduate School of Business at Rice University. 

Kevin Crotty is an associate professor of finance at the Jones Graduate School of Business at Rice University.

To learn more, please see: Crane, A. D., & Crotty, K. (2016). Passive versus active fund performance: Do index funds have skill? Journal of Financial and Quantitative Analysis​, 53(1), 33-64.