What to Know about Active Vs Passive Investing
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
Passive investing involves buying specific funds designed to match or track the performance of a particular index. For example, a passive investor looking to capture the broad market returns of US stocks may buy an index fund that tracks the S&P 500—a benchmark consisting of the 500 most valuable publicly traded US companies.[1] Active investing involves selecting specific securities or funds that you, or a manager, expect to outperform their comparative benchmark. For example, the manager of an actively managed US Large-Cap fund is betting that their mix of large US company stocks will outperform the S&P 500, after fees.[2]
Active investing sounds nice—who doesn’t want to beat the market? Therein lies the problem. Everyone wants to beat the market. However, simple arithmetic reminds us that not everyone can have a winning edge. For every buyer there is a seller. This means that the average investor must (by definition) get the market return, less fees. Bill Sharpe, Nobel Prize winning economist, summarized this point well 30 years ago when he wrote that “the average actively managed dollar must underperform the average passively managed dollar, net of costs.” In what follows, I set out to fact check Bill Sharpe’s claim by reviewing the actual data.
(But first, a few of my favorite quotes.)
You don’t have to do exceptional things to get exceptional results — Warren Buffett
Don’t do something, just stand there — Jack Bogle
Passive Investing is Less Expensive
According to Morningstar’s latest annual report on fund fees, average fees paid by active and passive US fund investors were on average 0.62% and 0.12% in 2020, respectively (see Figure 1 below). In other words, active US fund investors, on average, paid an annual fee premium of 0.50% of assets—i.e., for every $100K invested, on average, active fund investors paid $500 more per year in fees than passive investors. Over the last 20 years the average fee premium has been 0.63%. Thus, in order to meet their stated objective in 2020, active US fund investors, on average, needed to outperformed their comparative market index by at least 0.50%. To meet their objective over the last 20 years they’d have needed to outperform by about 0.63% per year. That’s a tall mountain to climb![3]
Figure 1. Average annual fees for active vs passive US fund investors (2000-2020)
Passive Investing Outperforms
Since 2002 a semiannual report called The SPIVA Scorecard has meticulously compared actively managed funds against their appropriate benchmarks. Since its inception, this report has served as the “de facto scorekeeper of the active versus passive debate,” and the data speaks for itself. Over time and across countries, actively managed funds (both stocks and bonds) consistently underperform their respective benchmarks, after fees. For example, the June 2021 SPIVA US Scorecard found that actively managed US Large-Cap funds generated an average return 0.97% less (= 8.61% - 7.64%) than the S&P 500 over 20 years, after fees (see Report 4 below). If the average S&P 500 index fund cost about 0.10% over that time, we can conclude that active US Large-Cap fund investors underperformed their passive counterparts, on average, by about 0.87% every year—that’s even worse than the 0.63% average fee premium (see Figure 1 above).
Not only do actively managed funds produce average returns that are significantly lower than their comparative benchmarks over time, the number of actively managed funds that fail to beat their benchmark is astonishing. For example, 93.80% of actively managed US Large-Cap funds underperformed the S&P 500 over 20 years, after fees (see Report 1a below). In other words, less than 10% of all active fund managers have lived up to their promise of outperforming the market—and that’s just over 20 years. For those of us investing for the next 30+ years, the results are likely to be worse.
Now, an (overly confident) active investor might look at this data and think: “Sure, only 10% of active investors can beat the market over 20 years, but about 30% may beat the market in any given year, and I’m confident I can repeat that outperformance year after year!” Again, the data speaks for itself. Actively managed funds that outperform their respective benchmarks in a given year rarely maintain that outperformance over time. In fact, outperformance fades rapidly. For example, the June 2021 SPIVA Persistence Scorecard found that of the 29.79% of actively managed US Large-Cap funds that outperformed the S&P 500 in the 12-month period ending in June 2019, only 12.30% of those repeated that outperformance over the following two consecutive years (see Report 1b below).[4] Choosing funds based on their previous outperformance is clearly a misguided strategy.
Passive Investing Is Less Risky
We’ve seen that active fund investors consistently underperform passive investors, after fees. However, there’s more to investing than just returns—risk is also important. Two investments that have the same expected return are indeed not created equal. The investment that exhibits less fluctuation in its price (i.e., risk) will always be preferred. Why? Because rational investors always expect to be compensated for taking more risk. Otherwise, why take the risk in the first place?
Proponents of active investing increasingly emphasize their aptitude for risk management. Even managers who admit they can’t expect to beat the index after-fees, often suggest that they can outperform in times of greater market volatility—i.e., that active managers outperform after adjusting for risk.
Again, the data speaks for itself. First, active funds are typically more risky than their respective benchmarks. Between 2007 and 2015 an average of 80% of US active funds demonstrated greater volatility than their category benchmarks. Second, after adjusting for such risk, active funds (again) consistently underperform their respective benchmarks. For example, the June 2021 SPIVA US Scorecard found that 94.05% of actively managed US Large-Cap funds underperformed the S&P 500 over 20 years, after fees and adjusting for risk (see Report 1b below).[5] In other words, less than 10% of all active fund managers have produced higher risk-adjusted returns than the market over 20 years.
Don’t Do Something, Just Stand There
When it comes to your investments, it pays to be passive. Year in and year out, across countries and asset classes, the data confirms that active investing underperforms passive investing, after fees and adjusting for risk. Buying index funds at lowest cost is simply the best strategy for nearly every individual long-term investor. Bill Sharpe’s argument has clearly stood the test of time.
Footnotes
[1] Passive investing has been around since John Bogle created the first index fund, tracking the S&P 500, back in 1976. That same fund is now the Vanguard 500 Index Fund, which has assets of nearly 1 trillion dollars and an expense ratio of 0.03%. In other words, for every $100K you invest, you pay just $30 a year in fees.
[2] Large-Cap refers to companies that have a large capitalization, or market valuation, relative to other firms. Typically, these are mature, well-known companies within established industries that have a market value of $10B or more.
[3] If you were to consider taxes, the mountain would be even higher as active fund investing generates a tax penalty as managers continuously buy and sell securities. In taxable accounts, such turnover leads to unnecessary taxes, hampering the fund’s after-tax returns. Average turnover rates for actively managed US equity funds is typically over 60%—i.e., in any given year, 6 out of 10 holdings in the fund are replaced. For comparison, the average turnover rate for the S&P 500 is about 1%.
[4] Furthermore, of the top quartile of actively managed US Large-Cap funds, as measured by performance in the 12-month period ending in June 2017, only 3.08% of those funds remained in the top quartile over the following four consecutive years.
[5] Risk-adjusted returns are calculated as the fund’s return divided by its standard deviation—a statistical measure capturing the average variability of a series of data around its mean. Risk-adjusted returns therefore represent a fund’s average return per unit of risk.