Last year, both strategies, often referred to as active and passive investing, had their moments. But the contest mostly came down in favor of index funds in 2006.
Mutual funds that mirror large and small-capitalization indexes outperformed a majority of managed funds last year, figures from Standard & Poor's Corp. show. The Standard & Poor's 500 index - a widely used benchmark for funds - beat 69.1 percent of managed large-cap funds, while the S&P SmallCap 600 index showed a greater return than 63.6 percent of managed smallcap funds, according to S&P. Among midcap funds, however, managers beat their benchmark, with 53.3 percent of managed funds outperforming the S&P MidCap 400 index.
"Stock picking skills can easily be swamped by a strong market movement," said Andrew Clark, an analyst at Lipper Inc. "It becomes difficult to beat your benchmark because everything is going up."
The S&P 500 did better than large-cap funds by more than 3 percent and the S&P SmallCap 600 beat smallcap funds by nearly 2 percent. Actively managed midcap funds topped the S&P MidCap 400 by 0.34 percent.
For the past five years, the S&P 500 has beaten 71.4 percent of large-cap funds, while the S&P MidCap 400 has outperformed 79.7 percent of midcap funds. The S&P SmallCap 600 has done better than 77.5 percent of small cap funds.
Mr. Clark notes that in the first half of 2006, before the stock market began its months-long run-up and the Dow Jones industrial average climbed to new highs, some managed funds held the upper hand because portfolio managers made some defensive moves as the market meandered.
"Indexing is a long-term strategy and it may on occasion test the patience of investors," said Sonya Morris, an analyst with investment research provider Morningstar Inc.
Mr. Clark said long-term investors need to remain disciplined and not react to every jump or pullback in the market when investing in index funds. "You're getting a greater return but you're also going to pick up a little more volatility if you stay entirely on the passive side."
Ms. Morris noted that index funds and most actively managed funds were burned by declines at the start of the decade when stocks spiraled amid an economic recession.
"Index investors weren't immune from the selloff," Ms. Morris noted. "But those that stuck it out have enjoyed above average long term returns."
One of the main arguments in favor of index funds such as the well-known Spartan 500 Index Fund is their low expense.
Ms. Morris noted that many of these funds are essentially commodities with little difference among them because they are tracing indexes. "There's very little reason under those conditions not to choose the cheapest one."
Of course, index funds are designed to match the market, not beat it. That's where the judicious use of managed funds can help add to investors' returns.
"I think it's a mistake to blindly adhere to one strategy or the other. There is a small minority of very talented investors who have shown an ability to beat the indexes over the long haul," Ms. Morris said.
She also noted that actively managed funds often prove their worth in certain investment categories, such as emerging markets, where managers might draw on local knowledge when making decisions.
Ultimately, however, she contends index funds can offer long-term investors who are unwilling or unable to do research on funds a wise, low-cost way to invest. The best index funds offer not only low expense ratios but also diversity in their holdings, low turnover and tax efficiency, she said.
"I think it can be a very potent strategy over the long haul for disciplined long-term investors," she said. "Sometimes the active-passive debate gets a little overblown and we lose sight of investors' overall goals."