If you took biology, you remember the first big split in the tree of life _ plants over here, animals there. The mutual fund business is like that _ actively managed funds on one side, index funds on the other.
And these two fundamentally different approaches to investing are in a constant struggle for supremacy. Managed funds hunt for the most promising stocks, which means they make constant changes to their portfolios; indexers simply buy and hold the stocks that make up an index such as the Standard & Poor's 500.
So which investing style is on top now?
In the big categories that matter to most long-term fund investors, it's the indexers, according to a new study from Standard & Poor's, the securities data company that brings us indexes such as the Standard & Poor's 500 for big-company stocks, the S&P 400 for midsize stocks and the S&P 600 for small ones.
The study also shows, however, that active-fund managers who zero in on specific stock sectors such as energy and health care have soundly beaten their benchmark indexes over the past five years.
For the first three quarters of this year, the S&P 500, the most widely used index, has produced better returns than 60 percent of the big-stock funds. For the past five years, it's beaten 53.4 percent of those funds.
The S&P 400 has beaten 53.5 percent of midsize managed funds this year, and 91.4 percent in the past five years.
And the S&P 600 has beaten 30.8 percent of small-size managed funds this year, and 69.4 percent for the past five years.
S&P does not operate funds itself and has no stake in the managed-indexer wars. The S&P indexes are meant to serve as benchmarks for investors and money managers to gauge their own results.
S&P's findings are generally consistent with other studies that have long shown that indexers beat most managed funds over time.
The evidence suggests that managers are simply not very good at finding hot stocks. This is especially so with big-company stocks such as those in the S&P 500. Those companies are so heavily scrutinized by Wall Street analysts and financial journalists that fund managers cannot find insights that others don't also see.
The other big factor is costs. The typical actively managed fund replaces all its holdings every year, forcing it to shell out a bundle for commissions, and to employ expensive teams of stock pickers.
Annual expenses at the typical managed fund come to about 1.3 percent of the value of the fund's assets. Indexers avoid most of these costs, keeping annual expenses to an average of 0.2 percent of asset value or less.
Over time, the money saved through lower costs stays in the index fund and compounds.
There are periods, of course, when managed funds do better. But the underlying question is: Was it skill or luck?
I side with those who think it's primarily luck. In fact, a recent study by the Economist shows that all the 10 managed funds that did best in the late '90s fell hundreds of places in the rankings in the subsequent years.
Even the managed funds that beat their benchmark indexes year after year may just be lucky, just as some coin flippers will have a string of heads.
Managed funds trounced the indexers over the past five years. But there are also some amazing swings.
In the quarter ended Sept. 30, for example, indexers beat less than 2 percent of the managed health-care sector funds. But over the past three years, indexers beat 81 percent of those funds.
What that means, is that this is a very volatile sector, with stocks making wide swings up and down. So the lead in the race between managed funds and indexers is constantly changing.
Investing in these narrow sectors is for short-term speculators, not long-term investors building nest eggs for retirement.
The S&P findings, incidentally, do not consider how managed funds' heavy trading affects investors who use taxable accounts. At the end of the year, all funds must pay shareholders the net profits realized on stocks the manager sold during the year. Tax on those gains further eats away at investment returns.
Annual taxes tend to be much lower for index funds because they make so few changes in their holdings. (Annual taxes aren't an issue if your fund is in a tax-deferred account such as a 401(k) or IRA.)
Sure, there are good managed funds out there. But this study, like many before it, shows that investors are wise to ask some tough questions before choosing a managed fund over a comparable indexer:
Is the fund manager really good or just lucky?
Are you qualified to spot the difference?
Even if the manager has a great long-term record, will he or she be around for the 10, 20 or 30 years you may want to have this investment?
How will costs and taxes eat into your returns over time?
With index investing, you don't have to worry that your "hot" manager will suddenly go cold or fall under a bus.
You can stick with the fund for the long term and know you can match the market's performance. The S&P 500 has returned about 10 percent a year over the long term, and has managed to maintain that record over the past decade despite the bear market from 2000 into 2002.
Matching the market is pretty good. And knowing you can do that on autopilot, without a lot of work and second-guessing, makes it easy to sleep at night.
_ Philadelphia Inquirer