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Who Will Slay the Index-Investing Dragon?

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What if the mutual fund industry throws a party and no one comes?

We’re not talking about the Morningstar Investment Conference, which kicks off Wednesday.

That annual institution, now in its 25th year, will be well attended by portfolio managers, research analysts and financial advisors looking for that extra edge in deciding where to invest.

But is the public still buying the idea that all these professionals add value? There are signs of an erosion in investor confidence in actively managed investing.

An article published in Friday’s Wall Street Journal titled “An Old-School Stock Picker Struggles with Index Craze” notes that the veteran value investor Wally Weitz’s reward for beating the S&P 500 index by 1% on average the past 3 years has been a withdrawal of $400 million in investor funds.

It also notes the case of the legendary investor Bill Miller, whose Legg Mason fund beat the S&P 500 for 15 consecutive years before succumbing to the housing meltdown. Still, Miller reclaimed his glory last year with a “fund that soared 40% and beat its benchmark by a wider gap than any other U.S. stock fund with $50 million or more in assets,” the Journal reports. Yet “investors pulled $196 million out of it.”

And these are not mere anecdotes. The paper cites Morningstar research indicating investors withdrew $127 billion from actively managed funds while moving $70 billion into index funds and ETFs.

The subject certainly touches a nerve among professional investors. An article by the financial advisor Marshall Jaffe called “Will Indexing Kill the Market?” was among the most widely read articles on AdvisorOne in May.

Jaffe, citing research by NYU professor Jeffrey Wurgler, says that the more popular indexing becomes, the harder it is for active strategies to beat passive funds as the market bids up the values of index-component stocks.

Noting that CalPERS, the largest pension fund in the U.S., is considering investing all of its assets in indexes, and suggesting that other large pensions must be engaged in similar deliberations, Jaffe argues we are in the midst of a massive index-driven investing bubble.

But, while the proportion of funds that are passively managed is at at an all-time high, the alpha seekers attending Morningstar’s conference should not despair.

Texas Tech finance professor and Research Magazine contributor Michael Finke, in a forthcoming article for the July issue of Research, cites a hypothesis that “the lack of valuation-motivated trades creates inefficiencies, leading to flows of investor dollars back to active managers to take advantage of these opportunities.”

Finke also cites other encouraging news for active managers. A 2009 paper by Martijn Cremers and Anttti Petajisto called “How Active is Your Fund Manager?” makes the case that the most active of active managers—that is, those who are not closet indexers—generate the greatest alpha over time.

“The more the fund deviates from the benchmark, the better it performs. And the relationship appears surprisingly linear and consistent,” Finke says in sum of the study, which has been downloaded more than 15,000 times—a huge number in financial research.

What’s more, Petajisto, in a new study, shows that stock pickers—again the most active stock pickers, excluding closet indexers—have outperformed not only over the past two decades but also during the financial crisis.

So there may solid reasons to cheer this Morningstar quest for alpha and look for the undiscovered genius who will poke a hole in the passive investing bubble that has been gaining dominance.

As Jaffe put it, indexers “are, in effect, saying that attributes like intelligence, experience, expertise, wisdom, intuition, patience and discernment—which we all prize as guides for every other aspect of our lives—don’t apply to investing.”

Who will be the next Benjamin Graham or Peter Lynch?