Why are you such big fans of index funds?

If you compare the Fidelity Low Price Stock Fund to Vanguard’s small-cap and mid-cap index funds, you will see Fidelity’s three-year, five-year and 10-year performance leaves the index funds in the dust. Fidelity’s fund is a small to midcap blend fund. If it’s so easy to find funds that do much better than index funds, why do you recommend index funds? If actively managed funds make you more money in the end, you’d be better off rather than worrying so much about expense ratios and turnover. Please answer my question. I am getting different answers from every advisor.

The debate between active and passive management has been going on for decades and will probably continue to do so. In the end, you must decide for yourself what to believe and what to do. I’ll give you my perspective plus some resources that show you why we believe in passive management.

What you have done is very easy. You have looked at the past and determined what you should have invested in, at least in this category of assets. If investing were that simple, everybody would do it, and we’d all be wealthy. The problem is you cannot invest in any past track record.

What you have not done is look into the future to see what the winners will be over the next three, five or 10-year period. Countless studies have been done trying to find a strategy or formula linking past performance with future performance. So far, that elusive link hasn’t been found.

As you have discovered, there are many salespeople and analysts out there telling you they can help pick the best active fund managers. They can describe the process these managers use, and the selection screens through which they put their managers. They can assure you that if a manager doesn’t perform, they will replace that manager.

The chosen managers most likely have excellent track records, and the appeal can be enticing. If you are interested in the pitch, you can ask to see their actual client results. More useful would be to ask which managers they were recommending in the past and how those managers did after the recommendation. In other words, what is the track record of the person who’s making the pitch to you?

Let’s look at the Fidelity Low Price Stock Fund, which as you point out has done well. We know now that it outperformed its benchmarks. We had no way to know this in advance, when the knowledge would have done us some good. As Paul Merriman has said many times, “There is no risk in the past,” because we know how the past turned out.

Of course, it’s equally true that we don’t know how well index funds will do. There is one very important difference that you need to understand. Actively managed funds are trying to beat the market. That’s how they attract money. Index funds do not try to beat the market; they accept the returns of the market.

Many academic and industry studies compare active and passive management.

Back in 1991, William F. Sharpe wrote an important paper called “The Arithmetic of Active Management,” in which he states, “Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.”

That, of course, did not end the debate. Eugene F. Fama and Kenneth R. French also discuss this topic in the DFA Fama/French forum on the Dimensional Fund Advisors web site.

As I mentioned, many studies seek clues to future performance based on past performance. In February, Vanguard published a new paper titled “Mutual fund ratings and future performance,” which concluded, that it’s extremely hard to find a quantitative system that accurately predicts future mutual fund performance.

Because many investors rely on Morningstar’s ratings of one to five stars as likely indicators of future performance (something we don’t recommend), Vanguard took a look at that. The researchers found that less than 40 percent of the funds ranked as five stars outperformed their style benchmarks in the 36 months after achieving that rating.

Investors who choose a five-star fund presumably hope that the fund will continue to have that ranking. Vanguard found that fewer than half the funds ranked as five stars still had that ranking one year later.

In the mid-1980s, Morningstar began publishing its star ratings, which were and are still based on risk-adjusted past performance. Morningstar publishes a wealth of data on the funds it covers and has always encouraged investors to consider multiple factors before investing. The company has never encouraged investors to use only the ratings to indicate or predict future performance, although many investors do just that.

Morningstar itself did a study, published in December 2008, looking back at funds that had its highest rating in 2003. Five years later, in the summer of 2008, the average five-year ranking of those former five-star funds in the domestic equity category was only 3.07: just barely above average.

We believe that most investors can achieve their long-term goals by accepting the returns of the markets without incurring the higher costs of active management. However, every investor must make that choice.