Once ridiculed, index funds now hold the reins in U.S. stocks

NEW YORK (AP) — They're simple, cheap and now the most popular way for many people to invest in the U.S. stock market: index funds.

Last month, for the first time, the number of dollars invested in funds tracking the S&P 500 and other U.S. stock indexes eclipsed those in funds run by managers trying to beat those indexes, according to preliminary data from Morningstar. With $4.27 trillion in assets at the end of August, U.S. stock index funds edged past the $4.25 trillion in funds run by stock-picking managers.

The figures don't yet include data from several dozen funds, so they could change as more funds report. But even if the precise moment didn't occur last month, industry watchers say it's likely inevitable that index funds will usurp actively managed funds' top billing. That's because investors have been consistently pulling dollars out of actively managed funds and shoving them into index funds for more than a decade.

"This milestone has been a long time coming," Morningstar said in a report.

It's a far cry from roughly four decades ago, when the first index mutual fund for individual investors hit the market to ridicule. Why would anyone be satisfied with average returns? Wouldn't investors always prefer the potential of better?

Turns out that average is pretty good when most funds fall short of it. Over the last 10 years, only 8% of actively managed funds that invest in a mix of large U.S. stocks beat their average index-fund rival.

Index funds have a head start in the race for returns because of their lower expenses. Higher fees mean actively managed funds have to perform that much better just to match the performance of index funds. The average expense ratio for stock index funds was 0.08% last year, which means they held onto $8 of every $10,000 invested, according to the Investment Company Institute. The average expense ratio for actively managed stock funds, meanwhile, was nearly 10 times that at 0.76%.

Of course, the rush to index investing has raised concerns of its own. If index funds get control of too much of the stock market, they could distort prices because money will flow into stocks based on how big a proportion they are of indexes, rather than how valuable investors see them as a company. Even the most ardent index-fund proponents acknowledge such a risk, but they say that tipping point is far away. U.S. funds control only about 30% of the total U.S. stock market.

Other criticisms center on index funds being overly concentrated in the hands of just a trio of fund companies — BlackRock, State Street Global Advisors and Vanguard.

The move to index investing has also been an uneven one. Investors still largely prefer the guiding hand of an active manager when it comes to the safe part of their portfolios. Bond index funds are less than half the total size of actively managed bond funds.

In foreign stocks, actively managed funds also still control more in assets than index funds. Like with bonds, active managers have a better track record of success for investing in foreign stocks than in U.S. stocks. But even there, the reign may be under threat. Investors pulled $89.5 billion out of actively managed international stock funds last month, only to plug $76.6 billion into their index-fund rivals. Actively managed international stock funds now control only $514 billion more in total assets than their index-fund counterparts.