From their very introduction in the late 1970’s. index mutual funds have been the target of criticism. At first, they were denounced as “settling for average” and were called “un-American” since they simply tracked a market rather than trying to beat the market. Subsequent attacks have focused on the construction of the underlying index and the impact of making portfolio changes when the index makes a change.

Of course, sellers of competing investment products have always made index investors feel they were missing some great opportunity. And with projections for stock market returns in the 7% to 10% over the next several years, based on earnings growth and already high valuations, marketers are trotting out the old pitch that the way to higher returns is to pick those sectors that are doing better than the broad market.

Frankly, these gripes all amount to the fans of a losing team criticizing a championship team. They may be disappointed and perhaps a little envious, but they at least acknowledge that the other team won.

Consider the logic behind index funds. The market return is made up of the returns of all the market participants, so some of those participants do better than the market and others do worse. Once the costs of investing are added, more participants drop below the cost-free market return. Further, the participants who better the market change frequently, so if an investor can expect to earn the market return with low costs through indexing, he will do better than most market participants over time.

This simple logic is continually supported by actual performance. According to Lipper Analytical Services, the Wilshire 5000 (a broad index representing the entire U.S stock market) outperformed over 50% of diversified stock mutual funds in 12 of the last 15 years. And for longer-term performance, the index bested nearly two-thirds of funds over 10 and 15 years. In bonds, the index comparison is even more striking, with bond indexes outperforming well over 80% of comparable funds for the 10 year period ending December, 2003.

But index funds are always fully invested in the index securities, so doesn’t the ability of an actively managed fund to raise cash or take other defensive measures give them an advantage in bear markets? Surprisingly, no. The Wilshire 5000 outperformed the Lipper General Equity Fund Average in 3 of the 6 bear markets of the last 30 years. In only one bear market, from December 1980 to July 1982, did actively managed funds beat the index by more than 2%.

These comparisons all use averages, so aren’t there funds that consistently outperform their benchmark index? You bet, but good luck picking them. Morningstar analyzed 10 categories of stock funds for the 10 years through 2001. They looked at the funds that performed in the top 25% of their category for a given period (one-, three-, or five-year) and then determined how many of these well-performing funds maintained their high ranking in the following period.

Only 30% of top funds in any given year were able to repeat their top 25% ranking the following year, and for three- and five-year periods less than 20% were able to repeat in the following period. The funds that did repeat tended to have low expenses compared to similar funds and a consistent, well-defined investment approach. Ironically, these are two primary advantages of index funds.

So why does the industry continue to push investment vehicles that are practically doomed to perform poorly? The obvious reason is money; the average active stock fund has expenses of around 1.60% of assets annually, while index funds are .30% or less. The difference, across the entire mutual fund industry, is billions of dollars. Hubris is also a factor; like many individual investors, fund managers are genuinely convinced that they will be the ones to beat the market. As the saying goes, pride goeth before the fall.

Despite the advantages of indexing, investors shouldn’t blindly rush into an index fund. Always determine your objectives and risk tolerance first and understand the risks of the market segment represented by the index. A portfolio of index investments can be constructed for almost any situation, and new index vehicles such as exchange-traded funds are being developed. Another effective use of index funds is as the “core” of a portfolio which then uses well-defined actively managed funds to emphasize the investment areas you feel have the greatest opportunity. In any case, review both your circumstances and the investment environment at least annually and make adjustments to keep your portfolio on track.