by Scott Burns

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Q: While meeting with my financial advisers recently, I raised this question: Why do we have a significant portion of my equity allotment in managed mutual funds when index funds outperform actively managed funds 80 percent of the time? The answer I received is that in rising bull markets, index funds indeed trump actively managed funds. But when markets are flat or declining, actively managed funds are superior. What does the research show? — R.W. Plano, Texas

A: The answer you received is interesting, but it isnt useful. Index funds are fully invested at all times. Managed funds tend to carry cash balances to meet redemption needs. Holding cash tends to reduce losses in bear markets. It also dilutes gains in bull markets compared to a fully invested benchmark index.

We can see some of this in the performance of managed funds over time periods out to 10 years. Over the 12 months ending Aug. 31, Morningstar data show that the average performance of all managed large-blend funds trailed the S&P 500 by 2.16 percentage points. They trailed the index by 1.72 percent annually over the last three years and 1.61 percent annually over the last five years. Since these periods include most of the recovery since mid-2009, thats a good indication that managed equity funds are likely to trail fully invested index funds during bull markets.

Over the last 10 years — a period that includes the crash of 2008 and early 2009 — the same group of funds trailed the S&P 500 Index by only 0.44 percent a year. Over the last 15 years, a period that includes two major market crashes, the average managed fund actually beat the index by 0.62 percent. This suggests that managed funds are at a smaller disadvantage during bear markets.

All of this is interesting, but not very actionable.

If your adviser was so convinced of the index fund advantage during bull markets, you might ask him why wasnt he committed to index funds over the last five years? My bet is that he will be a bit tongue-tied.

This kind of information has no value unless your adviser happens to know when bull and bear markets begin and end. Lots of people make claims about doing that, but the claims dont hold up to close examination. Mark Hulbert, editor of the Hulbert Financial Digest, demonstrates this on a regular basis in his newsletter. He has done it for decades.

The most fundamental question we face is how much we are willing to pay for a chance to beat the market. If you know that, on average, only 30 percent of managed funds can beat their benchmark and the cost of management over an index fund is 1 percent (really, it is a good deal more), then we need a good shot at getting an additional 3.33 percent annualized gain (1.00/0.30) to avoid the experience of buying bad lottery tickets. Basically, managed funds are a losing bet.

Managed funds may be interesting. They may have articulate managers. They may have the support of bright MBAs with powerful computer tools. But the arithmetic of management cost is against them.

Q: I am 47 years old, teach at a community college, and have $90,000 in student loans at 4.5 percent. The loan is currently amortized over 30 years. Also, I qualify for the Public Service Forgiveness Program (PSFP). However, for my loan to be forgiven (after 10 years — 120 payments), I must convert it to a 10-year loan.

This is the crux of my dilemma. It is a dilemma because converting from a fully amortized 30-year loan to one of the three 10-year plans adds to principal payment. While this would be OK, it hinges on the government honoring its forgiveness (PSFP) program over time. Therefore, it is subject to political change depending which party controls the White House.

Would you recommend changing to a 10-year payoff plan in order to qualify for PSFP, even though the PSFP can be changed in the future, leaving me with a higher payment? — J.S. by email

A: Inability to trust our government should not obscure the most fundamental reality — that switching to a 10-year payback period will save you a good deal of money all by itself. Rather than paying $1,824 for each $1,000 borrowed over 30 years, you will be paying back $1,244 for each $1,000 borrowed over 10 years. Basically, you would be cutting the total interest cost of the loan by 70 percent. So if you can cut your borrowing expense and, maybe, get loan forgiveness as well, thats a pretty good deal — and worth the risk.

(Questions about personal finance and investments may be sent by email to scott@scottburns.com. Please visit www.assetbuilder.com to comment on any of his articles, find referenced Web links or to discuss personal finance topics on his forums. Questions of general interest will be answered in future columns and on the website.