The debate over active and passive investment strategies, now more than 60 years old, shows no signs of ebbing.

If anything, this controversy has spawned a cottage industry, including dedicated blogs, sparring matches, and even a yearly scorecard—Standard & Poor’s Indices Versus Active, or SPIVA.

Despite the volume of data and opinion fueling each side, the bottom line remains that index funds predominantly outperform comparable active funds. But until now the industry hasn’t fully explored the following question:

Given that index funds tend to outperform active ones, will an all index-fund portfolio likewise outperform a portfolio of comparable actively managed funds?

Now, Alex Benke, CFP® and product manager at Betterment, Rick Ferri, CFA, founder of Portfolio Solutions, have tackled just that issue in an innovative new study.

Alex Benke, left, and Rick Ferri, discuss their research in a Dow Jones video last July.

Alex Benke, left, and Rick Ferri, discuss their research on a Dow Jones video last July.

In their analysis, originally released as a white paper in June 2013 and newly published this month in the Journal of Indexes, Benke and Ferri pitted all index-fund portfolios against portfolios holding comparable actively managed funds under six different conditions. The results demonstrate that “a diversified portfolio holding only index funds in all asset classes is difficult to beat in the short-term and becomes more difficult to beat over time,” the authors wrote.

The study documents yet another significant advantage of investing in index funds—and it unearthed several other insights that can serve as guiding principles for all investors.

Index funds perform better together

One of the first compelling new insights to emerge was that an all index portfolio tends to perform better than just the sum of its parts, compared to an active portfolio.

This surprising result emerged from the following test: The authors created a basic 60-40 portfolio with three of the most commonly held asset classes: 40% in a broad U.S. equity fund, 20% in a broad international equity fund, and 40% in a U.S. investment-grade bond fund.

They then compared this all-index portfolio to 5,000 portfolios of randomly selected, comparable actively managed funds over a 16-year period (1997 to 2012).

You can read details on the experimental methodology below, or in the white paper here.

The basic result was eye-opening, but not unexpected: The all index-fund portfolio outperformed the active ones 82.9% of the time during the 16-year period. The median annual shortfall of the losing active portfolios was -1.25%, and of those that outperformed, the median outperformance was 0.52%. (The authors note that while outperformance of actively managed portfolios is clearly possible, it wasn’t robust enough to make up for the downside.)

index fund portfolio

But what really stood out was the combined performance of the index funds. When the authors examined the individual performance of each index fund in the portfolio, they all tended to outperform comparable active funds—but the result was higher when taking the three index funds together.

Table 1. Estimated winning percentage of an all index fund portfolio over 16 years (1997-2012)

VTSMX (US equity: 40%)


VGTSX (Int’l equity: 20%)


VBMFX (US bonds: 40%)


Weighted 40%/20%/40%


Scenario 1 Results


As the authors wrote, “index funds, when combined together in a portfolio, have a higher probability of outperforming actively managed funds than they do individually,” a phenomenon that was persistent in every scenario they tested. While the weighted outperformance of the individual funds was 79.9%, the outperformance of the index portfolio as a whole was 82.9%.

Indexing long-term boosts returns

Next, the authors looked at the difference in the probability of an all index-fund portfolio outperforming an all-active portfolio in the short-term versus the long-term. The authors tested the same basic three-fund index portfolio as above, in three five-year periods ranging from 1998 to 2012, as well as that entire 15-year period.

Again, the results weren’t unexpected (as buy-and-hold investors could guess). In the long-term scenario, the outperformance of the all-index portfolio was higher than the average of each of the three five-year periods tested.

But here another striking phenomena emerged: The outperformance average for the three five-year time periods was 76.5%; but if you held onto the index-fund portfolio for 15 years, it outperformed a comparable active portfolio 83.4% of the time—a significant difference.

index fund portfolio

Reflecting real-world behavior

Needless to say, few investors actually stick to simple three-fund portfolios. To give their research more real-world validity, Ferri and Benke then added more asset classes to create equally weighted five-fund and 10-fund index portfolios, which they then tested against portfolios of comparable actively managed funds (also equally weighted).

Table 2. Index fund portfolio win rates and percentages by the number of funds 2003-2012

Run 1: Three-fund portfolio


Run 2: Five-fund portfolio


Run 3: 10-fund portfolio


But there was an unexpected twist to the results: It turns out that adding additional asset classes to the active portfolio actually reduced both its potential for loss, and its upside potential. The median win became smaller, and the median loss became smaller. Thus it seems that the more diversification there is in actively managed fund portfolios, the less variation there is relative to an all index fund portfolio.

How many funds do you need?

The real trouble for investors seems to lie in the assumption that more funds equals better performance. The authors note that many investors often hold more than one actively managed fund in each asset class (e.g. an investor might have a couple of U.S. equity funds to diversify fund companies or managers) to hedge their bets.

Is this a good idea?

No. In fact, as more active funds are added per asset class, this study found, the more an all index-fund portfolio is likely to outperform an all actively managed portfolio.

index fund portfolio

In other words: Multiple active funds within each asset class skunk performance. Adding funds to increase overall diversification helps the performance of an all index fund portfolio, as above, but when active investors add funds within asset classes it actually decreases an all-active fund portfolio’s performance.

Three guiding principles

Thus, Ferri’s and Benke’s research demonstrated the indexing advantage from the fund level to the portfolio level. It also surfaced three powerful insights that can serve to guide investors in their real-life choices.

  1. An all index portfolio is greater than the sum of its parts. Index funds, when combined together in a portfolio, have a higher probability of outperforming actively managed funds than they do individually.
  2. An all-index portfolio performs best over longer time periods: an all-index portfolio held for 15 years significantly outperformed the average of three five-year periods.
  3. Adding more funds within an asset class in an actively managed fund portfolio typically results in even worse underperformance relative to an all index-fund portfolio.

But of course, the merits of these conclusions hinge on the integrity of the methodology, which sought to level the playing field as much as possible between active and index funds.

Transparent methodology

In devising research conditions to deliver results that would be most useful for real investors, Ferri and Benke sought to imitate certain real-life conditions that investors face.

  • They only used funds that were actually available to investors during the time periods tested (avoiding so-called survivorship bias).
  • They used a common 60-40 equity asset allocation for both index and active test portfolios.
  • The three-, five- and 10-fund index portfolios tested were based on the most common passive (mostly) Vanguard funds.

The authors also made an effort to level the playing field between index and active funds in order to focus as much as possible on actual performance.

  • They excluded sales loads and redemption fees from active fund performance, because the fees have a negative impact on returns.
  • They selected the index fund share class with the highest expense ratio when two or more share classes existed.
  • The authors did not rebalance the portfolios in any of the tests; and they analyzed pre-tax performance even though index funds tend to have better tax efficiency.

How active funds were chosen

The authors used a random portfolio selection process to run 5,000 simulated trials of available actively managed fund portfolios, except in one experimental condition. In one of the test conditions, the authors applied a low-fee filter to the active funds, because so much research has documented that fees are the leading cause of underperformance.

But when they ran simulated trials only using funds that are in the lowest 50% in terms of their expense ratios (and excluding front-end and deferred load funds), the authors note:

A common belief in the investment community is that low-fee actively managed fund portfolios have a meaningfully higher chance for outperforming an all index fund portfolio. We find no evidence to support this view.

The authors conclude that future research could deepen this exploration by taking into account a longer time horizon (in this study, the authors were limited to a 16-year period because many index funds didn’t exist prior to 1997). And they recommend applying other filters to better hunt for alpha among active funds.

For example, new data shows that active managers who are truly active outperform those who are less active but still charge high management fees for their services. Perhaps this or other factors—e.g. funds with higher ratings or bigger AUM, the fund managers’ ages or education—could become other filters that might shed light on active funds’ top performance.

In the mean time, the jury’s no longer out: An all index-fund portfolio statistically wins.

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This article was published on February 3, 2014

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