Are investors fooling themselves in seeking to beat the market?

Can an investor outsmart the market?

That seemingly simple question has animated debates about investing for a very long time. When Princeton economist Burton Malkiel first published "A Random Walk Down Wall Street" more than 40 years ago, he translated an academic theory, the efficient market hypothesis, into everyday language.

Boiled down, it means most investors can't beat market averages over any extended period. Vanguard translated that theory into action, launching the first index fund available to retail investors tracking the S&P 500 in 1976. Then in 1993, Exchange Traded Funds (ETFs) came on the scene offering investors another low-cost index vehicle.

Today, 44 percent of households hold an average of three mutual funds with a total balance averaging $120,000, according to the Investment Company Institute. Approximately 14 percent of all mutual fund assets, or $2.2 trillion, are in index funds. That means investors continue to put the majority of their savings into actively managed mutual funds. That means most investors are betting they (or their mutual fund managers) can beat the market.

So it was interesting to read a recent report out of Morningstar Research updating what it calls its "active-passive barometer." The Chicago-based independent investment research house measured the performance of actively managed mutual funds compared with passive index funds over one-, three-, five- and 10-year periods, ending in 2015. While it does not claim to settle the debate, Morningstar found that few actively managed mutual funds beat their comparable passive index fund.

But that's just the headline. There is much more that can be taken away from the report. When you look at where actively managed funds did outperform their passive indexes, the Morningstar report reinforces some common-sense investing notions.

Underlying Morningstar's analysis is the idea that an actively managed fund's performance is measured against an index benchmark that matches the fund's investment objectives, based on criteria such as company size, growth vs. value investing, a focus on industry sector or geography and financial fundamentals such as dividend yield. A broad-based fund would compare its performance to the broad market index, typically the S&P 500, while a fund focused on small cap growth stocks would be compared to a passively managed index of small cap growth stocks and so on.

Here are the key takeaways highlighted by Morningstar as well as a few based on my reading of the data.

Fees matter. "They are one of the only reliable predictors of success," Morningstar reported. Stating the obvious, fees eat into performance. Fees, ranging from front-end loads to management fees, have been declining steadily over the past decade, in part because of competition from index funds and ETFs. But other fees, such as transaction costs, which are higher for funds with higher trading activity, remain invisible to investors. Across nearly every category, the lower the fees, the more likely an active fund was to outperform its passive index counterpart. For example, only 34 percent of all actively managed mutual funds outperformed their passive peers over a 10-year period, but the mutual funds in the lowest-cost quartile saw their success rate jump to 48 percent.

A long-term investment time horizon matters. Investing is not trading or speculating. Cable TV talking heads, much of the financial press, newsletter writers and bloggers feed a constant stream of market updates, rumors and conjecture, encouraging a short-term view. Morningstar found that value-oriented mutual funds, which by definition take the long view, "had higher odds of long-term success" (i.e. beating the index) than other fund types such as those chasing growth or special situation funds.

Active managers add can value through insight. Large-cap stock funds had the hardest time beating their index. Managers of mid-cap funds, small-cap funds and emerging market funds were more likely to outperform. That makes sense, since the largest companies have the most analysts following them, the most written about them and make up the greatest proportion of both trading volume and the largest indexes. An active manager researching an underfollowed small company has better odds of adding value than a manager holding Apple, for example.

Luck is not the same thing as investment skill. Morningstar reported a significant improvement in the number of active funds outperforming their index in 2015 compared to 2014. That's not surprising, since 2014 saw the fifth full year of an uninterrupted bull market. With the entire market rising it was more difficult for an active manager to stand out. But in August 2015, the market finally saw a long anticipated correction, with a 10-plus percentage point drop unfolding in one week. Though the market recovered in Q4, the last day of trading for the year pushed both the Dow and S&P 500 into slightly negative territory before dividends, the first down market since 2008. 2015 was a stock picker's market where active managers could stand out.

Brad Allen is a freelance journalist and former investor relations executive for firms including Imation Corp. and Cray Research. His e-mail is brad@bdallen.com.