Active vs Passive Management
What to decide? And why?
→ Active
Active investing involves hands-on portfolio management where investors or fund managers actively buy and sell securities, aiming to outperform a benchmark index by carefully selecting investments based on research, market timing, and analysis.
This approach typically incurs higher fees and trading costs due to the frequent transactions and expertise required.
→ Passive
Passive investing, in contrast, follows a "buy and hold" strategy that involves purchasing index funds or ETFs that mirror the performance of a specific market index, like the S&P 500.
This approach is based on the belief that markets are mostly efficient over time, and it's difficult to consistently outperform them.
Passive investing usually has lower fees and requires less ongoing management, making it an attractive option for long-term investors who prefer a more hands-off approach.
The Historical Comparison
Historical data shows that the majority of actively managed funds underperform their passive benchmarks over long time periods, particularly after accounting for fees and expenses.
Studies from firms like S&P Global have found that 80-90% of active U.S. equity funds fail to beat their benchmark indices over 10-15 year periods, with similar patterns observed across different market sectors and geographical regions.
The primary reasons for this under performance include:
higher management fees (often 0.5% to 1.5% for active funds versus 0.03% to 0.2% for passive funds),
trading costs that eat into returns
the difficulty of consistently making successful market timing decisions,
the mathematical reality that the market return is the average return of all investors before costs
Active Management Performance (1993-2023):
Source: S&P Dow Jones SPIVA Scorecard
S&P 500 active funds: ~80% underperformed index over 10-year periods
Only ~10% of active managers consistently outperform benchmarks
After fees, average active fund underperformed index by 1-2% annually
Higher underperformance in efficient markets (large-cap US)
Better active results in less efficient markets (small-cap, emerging markets)
Morningstar Fund Analysis
Below is data that suggests limited predictive value of Morningstar ratings for future fund performance. 87% of 1-star funds improved their rating, showing strong mean reversion at both rating extremes.
Key findings:
Star persistence weakest at extremes (5-star and 1-star)
Mean reversion common
88% of 5-star funds declined in ranking
Past performance not indicative of future results
What about Fixed Income Over the past 5 years (through 2023)?:
- 65% of active fixed income managers underperformed the AGG ETF
- 35% outperformed the benchmark
This shows higher success rates for active management in fixed income compared to equities, likely due to market inefficiencies and non-index opportunities in bonds.
What to decide?
The decision between active and passive investing should be based on your investment goals, time horizon, and personal preferences.
Consider passive investing if you
Prioritize lower costs
Prefer a hands-off approach
Want broad market exposure
Accept market-level returns
Active investing might be more appropriate if
You're willing to accept higher fees for the potential of outperformance,
Have strong conviction in a particular investment strategy or manager,
Want to implement specific values-based investing criteria, or
Are investing in less efficient market segments like small-cap stocks or emerging markets where active managers may have more opportunities to add value.
Many investors ultimately choose a core-satellite approach, using passive investments for the majority of their portfolio while allocating a smaller portion to active strategies in areas where they believe active management can add value.