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Index fund returns keep getting better the longer you hold them. This is because low-cost index funds give you more of the market’s return and because many actively-managed funds eventually go under. A combination of cost savings and longevity help index fund returns float to the top in rankings.

Index funds and exchange-traded funds (ETFs ) that follow indices seek to track the returns of a market benchmark, such as the S&P 500 Index. They buy and hold all, or a representative sample, of the same securities in the index to replicate its performance. Index funds, on average, cost about one-fifth the industry average for actively-managed funds, so you keep more of the market’s return.

Actively-managed funds try to outperform market benchmarks. The fund managers rely on research, market forecasting, and the experience and expertise of their portfolio management team. Higher costs are always incurred with active management, whether the fund outperforms its benchmark or not.

The year-over-year performance of index funds will never be superior to a market’s performance (by definition), and many actively-managed funds will outperform each year. There’s about a 40 percent probability that an actively-managed equity fund will beat its benchmark any given year, according to the latest S&P Indices Versus Active Funds Scorecard (SPIVA). Figure 1 highlights the percentage of active funds that have outperformed indices annually over a 10-year period ending in 2012.

Figure 1: Average Annual Percentage of Active Funds that Beat their S&P Benchmark

Source: S&P Indices Versus Active Funds Scorecard (SPIVA) 10-year average ending in 2012

About 40 percent of actively-managed equity funds have beaten indices annually since 2000. This winning percentage is for one year. It declines as the time period expands. By 5 years, only about 34 percent of the starting funds outperform their benchmark. By 10 years, only about 27 percent of the original funds have outperformed, and by 20 years, the percentage drops to about 20 percent. Figure 2 highlights this drop in probability by time period.

Figure 2: Percentage of Actively-Managed U.S. Equity Funds that Beat their Benchmarks

Source: Vanguard, “The Case for Indexing” April 2012; S&P SPIVA 2012 Report, The Power of Passive Investing. Wiley, 2011

Why is there a drop in the percentage of winning active funds over time? The answer is attributed to two factors: first, the drag of higher active management fees over longer periods; and second, the high volume of fund closures and mergers.

Actively-managed fund expenses are about 5 times higher than comparable index funds expenses. This added cost erodes fund performance over time and the effect shows up in fund rankings.

Closures and mergers also have a more subtle effect on the outperformance rate. The mutual fund industry is a revolving door. Poor performing funds are constantly being replaced with new funds. The purging of poor performing funds from a mutual fund’s data creates a “survivorship bias” in the performance statistics. You only see the better performing fund returns in the long-term data because they’re the only ones that survived.

Figure 3 highlights the percentage of actively-managed U.S. equity mutual funds that have closed or merged over the different time periods. The closure/merger rate of equity funds has averaged about 6 percent per year, 25 percent over a 5-year period and 50 percent over 20 years. Terminations climb at a slower rate after funds have established a long-term track record.

Figure 3: Percentage of Actively-Managed U.S. Equity Funds Closed or Merged

Source: S&P Indices Versus Active Funds Scorecard (SPIVA) year ending 2012, Power of Passive Investing, Wiley, 2011

A survivorship bias-free database acknowledges this issue and includes closed and merged fund performance in their data. This methodology correct survivorship bias by providing a full comparison of all funds that were available at the beginning of each period.

Actively-managed funds have a much lower percentage win record over time when a survivorship bias-free database is used. This is why the percentage of winning active funds declines as time passes.