Updated March 2025
ACTIVE VERSUS PASSIVE INVESTING
Abstract: This article was originally written and posted on our website in 1995. Additional research has been included in numerous updates. The story remains the same. A large, well-replicated and expanding number of studies have clearly proven the advantages of passive over active management. Active management promotes the narrative that experienced and talented asset managers can beat the market through research and timing and trading markets. Well replicated research over decades, largely from academia, has shown that after management expenses the majority of active managers underperform largely untraded passive and index portfolios. Active management frequently costs 1% or more annually than passive management in equity portfolios, 0.5% or more in fixed income, and recent academic research has exposed hidden and very high fees in the hundreds of billions over the last decade. Exceptional active managers cannot be chosen in advance since, with the exception of underperforming managers investors would not want to choose, there is little or no consistency in manager performance and outperformance may be due to luck. Dalbar has studied the returns real investors receive in brokerage accounts for over 25 years and they are disappointing. Dalbar, very well respected in the industry, concludes that most investors would get better returns from putting their money in bank CD's.
WHAT IS ACTIVE MANAGEMENT?
Active management might best be described as an attempt to apply human intelligence to find "good deals" in the financial markets. Active management is the predominant model for investment strategy today but has been declining in influence for many years. Active managers try to pick "attractive" stocks, bonds, and mutual funds, time when to move into or out of markets or market sectors, and place leveraged bets on the future direction of securities and markets with options, futures, and other derivatives. Their objective is to make a profit, be opportunistic, and to do better than they would have done if they simply accepted average market returns. In pursuing their objective active managers search out information they believe to be valuable and often develop complex multivariate proprietary trading systems. The majority of trading today on the major exchanges is done by high frequency trading computers programmed to trade news headlines and technical formulas in time frames varying from milliseconds to four or five days. This is gambling and speculation, not investing. Active management encompasses hundreds of methods and includes fundamental analysis, technical analysis, and macroeconomic analysis. These all have in common an attempt to predict the future and determine profitable future investment trends and prices.
WHAT IS PASSIVE MANAGEMENT?
Passive investment management makes no attempt to distinguish attractive from unattractive securities, or forecast securities prices, or time markets and market sectors. Passive managers invest in broad sectors of the market called asset classes or indexes and, like active investors, want to make a profit. However, they accept the average returns various asset classes produce. Passive investors make little or no use of the information active investors seek out. Instead, they allocate assets based upon long-term historical data delineating probable asset class risks and returns, diversify very widely within and across asset classes, and maintain allocations long-term through rebalancing of asset classes.
WHAT IS INDEX INVESTING?
Index investing is a form of passive investing in which portfolios are based upon securities indexes which sample various market sectors. Indexes are constructed by committees, the committees usually meet every six months, and the indexes are often called benchmarks. Indexes are reconstituted in these committe meetings with poor performers deleted and good performers added. Thus, indexes are not constants or stable benchmarks but variables and are significantly influenced by price momentum and opinion. Best known of all indexes is the Dow Jones Industrial index, a basket of thirty very large U.S. companies. Only one of the companies in the Dow Jones Industrial index in 1929 is still in the index today, GE, illustrating the ever-changing variability of so-called benchmarks. Indexes are available for domestic and international equities and fixed income, industry sectors, commodities and gold, and virtually all asset classes.
WHICH WORKS BEST?
Research supporting passive management comes from the nation's universities and privately funded research centers, not from Wall Street firms, powerful banks, insurance companies, active managers, and other groups with a vested interest in the huge profits available from active management. Results from this research are clear and indisputable. Active investment management is an appealing mirage which substantially boosts costs and decreases returns compared to properly designed passive and index portfolios. Active management does not do better in bear markets or allow investors to avoid losses although that is frequently claimed. Marketwatch (7-31-15) quotes John Bogle, founder of Vanguard funds,"The job of finance is to provide capital to companies. We do it to the tune of $250 billion a year in IPO's and secondary offerings. What else do we do? We encourage investors to trade about $32 trillion a year. So the way I calculate it, 99% of what we do in this industry...it's a waste of resources".
MARKETS AND ECONOMIES ARE UNPREDICTABLE.
Given that there are thousands of stock market experts, mutual fund managers, private money managers, and advisors, some active managers will make spectacular calls and accurate predictions some of the time. And, when they do this small group usually attributes it to their skills, not luck. Yet, extensive research has shown that, as a group, the performance of experts is what would be expected from chance guessing, there is no way of knowing in advance who will make the right call, and past predictive success is unrelated to future predictive success. The problem is that investment returns are the result of numerous unpredictable factors themselves. Political, social, technological, emotional and other factors effect market prices and these cannot be foreseen or predicted in advance. These are discussed elsewhere on our website in "Financial Superstructures". In addition, those who attempt to predict the future often employ flawed models or data which make sense but only apply during a very restricted sample of time. For example, studies have found that past earnings growth for companies is only weakly correlated with future earnings growth or stock prices. Never-the-less, active managers and investors watch earnings reports for clues to the future price of a stock and buy stocks based on earnings predictions. Numerous studies of brokerage firm analyst earnings predictions clearly show a strongly optimistic bias.
Economists in both the public and private sector provide a continuous series of data and forecasts in an attempt to predict future economic and investment trends. Yet, numerous studies have found that economists cannot predict major turning points in the economy and their forecasting skill is, on average, about as good as chance guessing. Economic data is of questionable quality and subject to frequent major revisions. For example, one study found that Federal Reserve economists did significantly worse than chance in predicting economic growth and turning points in inflation from 1980 through 1995. As of 2011, Fed Chairman Ben Bernanke's record in predicting economic trends was almost 100% incorrect, an inverse predictor of future economic developments. An article on "Economists and Economics" examines this problem elsewhere on our website.
FUTURE SECURITIES PRICES ARE UNPREDICTABLE.
Several statistical studies have found that the price behavior of securities, such as stocks, bonds and commodities, is indistinguishable from that of random numbers over intermediate and shorter time frames. Patterns in numbers occur and technicians attribute great signficance to them but they have no demonstrated persistence or predictive power. We examine weaknesses in mean-variance models commonly used in securities analysis elsewhere on our website site in "Risk and Return". Over many decades, the prices of equities, real estate, and gold trend upward due to inflation, currency debasement, and economic growth. Otherwise, future securities prices are unpredictable. However, selling predictions is a big and profitable business. Sherden examines this in "The Fortune Sellers", referenced below.
Academic research (Carey, W. U. Arizona, 2017 draft) on historical returns indicates that knowing which equities will outperform the market in advance is near impossible. They examined the total data base for all stock prices in the CRSP data base for all common stock returns from their first appearance on an exchange through their delisting for the 1926 to 2016 period. Only 42.6% of stocks gave a buy and hold return inclusive of reinvested dividends that exceeded the return on one month Treasury bills over the same time horizon. Individual stocks tend to have rather short lives with a median listed time on exchanges of 7.5 years. The single most common return for returns rounded to the nearest 5% over a listed lifetime for a stock was a loss of 100%. A total of 25,300 companies issued stocks that appeared in the CRSP common stock database between 1926 and 2016. Of these, the 1,092 top-performing companies, slightly more than 4% of the total, account for all of the "wealth creation" in common stocks between 1926 and 2016. The odds of choosing a wealth creating individual equity or group of equities are clearly rather slim. Passive equity asset class funds or index samples are highly likely to outperform stock pickers long term. Of course, there will always be a small minority of stock pickers who beat the markets for some period of time but there is little chance we can know who they will be in advance, there is little chance their outperformance will persist over long time frames, and their is little chance their outperformance is due to skill. The future is largely unknowable.
RISK AND RETURN ARE ABSOLUTELY CORRELATED.
High potential returns always involve high potential risks. There are no low-risk high-return investments. Investment risk comes in many forms but to most investors risk means the potential for losing investment capital and the duration or permanency of that loss. Through analyzing the best available long-term data academic researchers have provided estimates of risk, defined statistically as volatility, and mean returns. These findings provide our best approximation of future risk and return for any given asset class or mix of asset classes and clearly show that there are no low risk high return asset classes. Never-the-less, Wall Street continually introduces and promotes new and appealing alternatives supposedly immune to this solidly proven principle. An article on our website, "Risk and Return", examines risk and return in detail.
ACTIVE MANAGEMENT IS MORE EXPENSIVE THAN PASSIVE MANAGEMENT.
Active investors must overcome many costs to match the returns of the average passively managed portfolio. These include trading costs, much higher management fees, market impact costs as active managers affect the prices they pay, dilution from maintaining higher cash positions than passive managers, taxes in taxable accounts due to high turnover rates, and, commissions if an investment product, like a mutual fund, is purchased through a broker or financial salesperson. These costs create a handicap for the active investor of 1% to 4% per year depending upon asset class mix and whether commissions are involved. According to the Financial Times (8-7-18) the average active equity fund has an expense ratio of 1.15% and fixed income fund, 0.9%. Passive or index portfolios have expense ratios running a very low 0.04% up to about 0.40% depending upon asset class. Since the highest quality available long term data in studies going back to the late 1800's indicates real inflation adjusted global equity returns around 5% and fixed income returns around 1.5-1.8%, fees around 1% annually consume about 20% of inflation adjusted investor returns in equities and a whopping 50% or more in fixed income. "Managing" money can be very profitable for those who do it.
The Financial Times (8-6-18) reported that US private equity managers running active portfolios had extracted $400B in fees and expenses from investors since 2006 but on average failed to beat returns in the S&P 500. Complex and opaque agreements often allow private equity managers to charge multiple layers of hidden fees. According to the lead academic in one study on management expenses, "We do not know the exact total of fees and expenses paid by investors because a lot of effort is spent...to ensure this information remains as secret as the recipe for Coca-Cola."
ACTIVE MANAGEMENT IS MORE RISKY THAN PASSIVE MANAGEMENT.
Active managers attempt to choose securities which will outperform the market and thereby often concentrate their investments across relatively few securities. If an active manager bets wrong they may very significantly underperform market averages. Passively constructed portfolios, however, are highly diversified and DFA's asset class portfolios hold thousands of securities allocated across various asset classes which have been identified by research and have predictable and roughly quantifiable risks and returns. They never produce exceptional returns but also never produce exceptional losses compared to their respective asset class(s). An example of unexpected risk in active management performance is illustrated by the Legg Mason Value Trust when it was managed by Bill Miller, a major name in the financial industry. From 1991 through 2005 the fund outperformed the broad market every year, a winning streak no other fund manager has come close to matching. Then, in 2008, the fund dramatically underperformed the S&P 500, wiping out nearly 20 years of market-beating performance. As of December 2008 the fund was one of the worst-performing in its asset class for the prior one, three, five, and 10-year periods. Mr. Miller told the WSJ, "he failed to consider that the (financial crisis) would be so severe, and the fundamental problems so deep, that a whole group of once-stalwart companies would collapse." Once again the future turned out to be unpredictable.
Extensive academic research has shown that asset class diversification with passive and index funds produces higher returns with lower volatility than simply investing in one or two asset classes, typical of most active management strategies. This is covered elsewhere on our website in "Portfolio Design".
ACTIVE MANAGERS UNDERPERFORM PASSIVE MANAGERS.
Because of increased costs and risks, about 65% of active managers, as a group, underperform passive portfolios during any given year and, over time this percentage increases until only a few outperform market averages. DFA examined the percentage of active equity funds which failed to beat their respective indexes from July 2004 through June 2009. It ranged from 63% for US large cap growth to 90% for emerging markets. For the same period, between 93% and 100% of actively managed fixed income funds failed to beat the market. Worse still, survivorship bias increases the apparent returns of active managers. On average 5.7% of the actively managed equity fund universe disappeared each year and by the fifth year, 28.5% of the fund universe had disappeared. Only about 33.2% of actively managed funds outperformed their index benchmarks in 2004 and five years later, only 1.4% of the surviving funds had outperformed their benchmark every year. In the period ending December 31, 2014 only 56% of the active equity funds had survived for ten years and only 18% of those surviving beat their benchmarks. Survival rates for fixed income funds were similar to those of equities and outperformance of bond index benchmarks was even lower at 13%. The odds of beating indexes and equity asset class funds are very low.
The Financial Times (2-6-12) reported a study of fund managers done by Merrill Lynch. Only one in five managers of US stocks managed to outperform the US stock market in 2011, almost an exact repeat of 2010. Only 23% of active managers outperformed the S&P 500 from 1-31-14 through 1-31-15. Active fund managers with a focus on growth stocks fared particularly poorly in 2011 with just 11% beating their benchmark and an average underperformance of 4.5%. An S&P Dow Jones study reported on Marketwatch.com (10-10-12) found that in the five years through June 2012 fewer than a third of active equity managers and only 3% of active long-term bond portfolio managers beat their respective benchmarks. On 4-12-17 the WSJ reported that for the 15 years ending in December 2016, 95.4% of US mid-cap funds, 93.2% of US small cap funds, and 92.2% of US large cap funds trailed their respective benchmark indexes. Remarkable! European mutual funds show similar underperformance of active fund managers as in the US. From June 2008 through June 2018 just two of 49 fund categories showed outperformance by active fund managers (Morningstar). Morningstar research evaluated active funds against a compositon of passive funds rather than a costless index (Financial Times 10-1-18).
Past active manager outperformance doesn't predict future outperformance. Of the 452 domestic equity funds in the Morningstar database that existed for 20 years for 1990 through 2009 only 3% outperformed their respective indexes and that doesn't take into account survivorship bias mentioned in the prior paragraph. Several studies have shown that Morningstar "star" ratings have no predictive value. For example, of the 248 stock funds with Morningstar's (highest) five star rating in January 2000, only four, or 1.6% kept that rank after ten years (12-31-09). The odds of picking which active manager will outperform their respective index for longer time frames in advance are about 1 to 1.5 out of 100, not much. A Dow-Jones team looked at 2,682 mutual funds that had been operating for at least 12 months through March 2010. Just two funds landed in the top quartile for five consecutive years through June 2014. There was little evidence of consistent performance. Another Morningstar study examined five broad equity and fixed fund categories over multiple periods beginning in 2005 and running through March 2010. They found that, "In every single time period and data point tested low-cost funds beat high-cost funds." Expense ratios are the only variable which matters significantly in predicting future fund returns to investors.
S&P also did an analysis of persistence, "The S&P Persistence Scorecard". They concluded, "Very few funds have managed to consistently repeat top-half or top-quartile performance. Over the five years ending September 2010 only 4.1% of large-cap funds, 3.8% of mid-cap funds, and 4.6% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Expectations of a random outcome would suggest a rate of 6.25% so funds, in the aggregate, showed no evidence that past performance persisted. The study was repeated for the five years ending March 2011 with the same conclusions.
In "The Drunkard's Walk" physicist Leonard Mlodinow examines randomness and the statistical basis of Bill Miller's extraordinary winning streak. He references a Credit Suisse First Boston newsletter published a few years before the winning streak ended which calculated that the odds of a manager outperforming the market on chance alone for 12 straight years were one in 2.2 billion. Surely, chance could account for a few good years but not such an extraordinary and sustained performance. Mlodinow notes, however, that the CSFB statisticians were considering the odds that a specific fund manager chosen at a specific point in time would outperform for the next 12 years straight. Mlodinow poses a question, "if thousands of people are tossing coins once a year and have been doing so for decades what are the chances that one of them, for some period 15 years or longer, will toss all heads?" He calculates the probability that some fund managers in the last four decades would beat the market each year for some period of 15 years or longer. That probability is almost 3 out of 4. Bill Miller's winning streak didn't differ from what we would expect from chance samplings of mutual fund manager performance.
Active managers do not do better in bear markets, a frequent claim. In 2008 during the financial crisis Morningstar found that stock-index funds lost 39.1% compared to 40.5% in actively managed funds. Standard and Poor's states, "One of the most enduring investment myths is the belief that active management has a distinct advantage in bear markets due to the ability to shift rapidly into cash or defensive securities. We dispelled this myth in 2003 using a case study of the 2000 to 2002 bear market. The downturn of 2008 provided another case study. The results are similar, with under performance across all nine style boxes." DFA examined the percentage of active equity funds which failed to beat their respective indexes from July 2004 through June 2009. That period includes a very strong bull market and the second largest equity market decline in the last 100 years. DFA found that active managers underperformed their respective asset classes from between 63% for US large cap growth stocks to 90% for emerging market stocks. Active management in Q116 failed in a very volatile quarter with only 19% of large cap US funds beating the S&P 500 and only 19.6% of value funds beating their benchmark and only 6 percent of growth funds beating their benchmark (Financial Times, 3-5-16).
When matched for asset type and portfolio mix passive and index managers outperform active managers by about 1.5% to 2% per year on average after all costs. DFA has calculated that it would take an outperformance by about 5% annually for 64 years to prove that an active manager has outperformed a comparable passive portfolio. An analysis of returns by the S&P's SPIVA scorecard published by DFA on 11-20-19 clearly showed that for the 15 year period ending in mid-2019 the average actively managed equity fund underperformed equivalent passive funds by 0.74% per annum after expenses and that a large majority of active managers underperformed in 14 different equity categories. Most investors probably do not know that the life span of equity funds is relatively short and survivorship bias is a serious problem. Over the last 15 years through mid-2019 a stunning 57% of US equity funds, 49% of international equity funds, and 52% of all fixed income funds were merged or liquidated. Only data from surviving funds is reported and that very significantly boosts returns and creates a bias.
INVESTORS EMPLOYING ACTIVE MANAGEMENT DO FAR WORSE THAN THE ADVERTISED PERFORMANCE NUMBERS AND WOULD PROBABLY DO BETTER BUYING TREASURY BILLS OR C.D.'S AT A BANK.
Studies of real returns achieved by real investors in real brokerage accounts are rare. Two studies covering ten to fifteen year time frames have found that broker advised investors, and investors self-managing their accounts, captured only one-quarter or less of the total returns produced by indexes and less than half the return reported by managers and mutual funds. This is due to the tendency of brokers and investors to listen to media pundits, move positions too rapidly, enter or leave asset classes at the wrong time, chase hot stocks and funds and managers, and run up management trading costs. A study conducted by the New York Times pitted five prominent advisors specializing in mutual fund selection (including the owner of Morningstar) against the S & P 500, a widely used index benchmark. The best advisor lagged the S & P by about 40% for the six years from 1993 through 1997.
Dalbar, an investment research firm, has performed studies of stock and bond investor returns versus the S&P 500 return and Barclay's US aggregate bond index for many years. Their 2012 update covered January 1992 through December 2011, a 20 year period. Dalbar found that the average retail equity fund investor received 3.49% annually versus 7.81% for the S&P 500, trailing it by a large 4.32% annually. Coincidentally, 4.32% is about the size of the equity premium over T-bills. Investors would have done just as well buying T-bills or CD's. The average bond fund investor received 0.94% versus 6.50% for the Barclay's Aggregate US bond index, trailing it by 5.56% . Inflation averaged 2.56% so the average stock investor only beat inflation by 0.93% and the average bond investor lost 1.62% annually after inflation for 20 years. As of 12-31-2014 Dalbar's trailing 30 year data show that the average US equity fund investor received an annual return of 3.79% versus 11.06% in the S&P 500 index and an average annual return of 0.72% in fixed income funds versus 7.36% in the Barclays Aggregate Bond index.
It's important to note that there are a few critics of the Dalbar studies. Pfau (3-16-17) argues that Dalbar's methodology for calculating average investor returns unfairly understates returns. Dalbar has responded by stating that Pfau is impudent and his analysis totally flawed. In any case, Dalbar's data clearly indicates that real investors in real brokerage accounts and mutual funds do far worse than reported fund returns over time. Supporting this is performance data from active funds and traded accounts. The Wall Street Journal (10-3-12) published data from a Morningstar study indicating that active investors manage to dramatically mistime buying and selling decisions. In the 10 years through August 2012, Dodge and Cox's $37 billiion DODFX, their international stock fund, gave an annualized return of 9.61% while annualized investor returns were -1.17%. Investors moved in and out of positions at the wrong times and greatly reduced their returns. Research on traded retail accounts by Barber, Odean, and others confirms the Dalbar and Morningstar studies and shows that the majority of traders lose money and high trader portfolio turnover reduces returns the most.
As noted above, the investment industry, with one or two exceptions, has not seen fit to undertake studies of actual investment account performance for real investor accounts. It would be quite easy to randomly sample accounts for stockbrokers and self-directed investors and calculate what investors received. Registered Investment Advisors calculate real internal rates of return (IRR) for their accounts. EAM reports this data to our clients every 90 days or upon request. But, Wall Street's investment products are sold on past performance or promised performance of the product or investment strategy, not what real investors received. Reduced to its simplest element, the investment business is a business of selling numbers attached to "paper" assets, stocks and bonds. Few things are more intangible. If the numbers in real account holding assets for real investors were high it is virtually certain we would see them incessantly repeated in promotional and sales materials from the financial industry. Real investors, on average, have gotten very little from investment markets after fees and failed investment strategies.
"EXCEPTIONAL" ACTIVE MANAGERS CANNOT BE IDENTIFIED IN ADVANCE.
A tiny handful of superstar money managers with outstanding past performance are consistently featured in financial media as evidence for the benefits of active management. Yet, no one knew in advance who would outperform, the odds of selecting one in advance were very low, and the results they achieved in the past may be due to luck. Hundreds of carefully done studies have found that past performance of money managers, mutual fund managers, investment analysts, and others is unrelated to their future performance. Track records mean little. Two of the most respected, top performing, and successful active managers of our time, Warren Buffet and Peter Lynch, both recommend index investing.
Morningstar reported on a study of pension fund consultants who were paid to select the best active US equity fund managers. They concluded: "We find that consultants recommendations on funds...have a very significant effect on fund flows (money going into or out of the fund), but we find no evidence that these recommendations add value to plan sponsors (i.e. investors)."
ASSET CLASS MIX EXPLAINS OVER 90% OF PORTFOLIO RETURNS.
An asset class is a group of securities which have similar risk and return characteristics. One year Treasury bonds, or commercial real estate, or small company U.S. growth stocks, or emerging market stocks, are examples of asset classes. Research has clearly established that portfolio performance differences between different professional money managers are due predominantly to the asset class(es) they choose. Markets, not managers, produce returns.
THE "SMART" MONEY USES PASSIVE INVESTMENT STRATEGIES.
An estimated 40% to 50% of all institutional money as of 2019 was in index or passive portfolios and an estimated 45% of retail investors (CNBC 3-19-2019) make use of passive strategies. The latter number has roughly doubled in the past 10 years. Passive strategies are employed by AT&T, CALPERS, IBM, Intel, K-Mart, PacTel, Pepsi, and Stanford University, among many others. From 2009 through August 2016 about $500 billion flowed out of active funds and $1.4 trillion flowed into passive funds (BofA data).
REFERENCES:
Bernstein, William. The Intelligent Asset Allocator, McGraw-Hill, 2001. A detailed look at asset allocation in passive and index portfolios. It may be advanced for readers uncomfortable with statistics.
Bogle, John. Common Sense on Mutual Funds, Wiley, 1999. A thorough examination of research on passive and index investing and the disadvantages of active management from the founder of Vanguard mutual funds and the first retail S & P 500 index fund.
Clyatt, Bob. Work Less, Live More, Nolo, 2005 A clearly written and practical look at "early semi-retirement". This book emphasizes lifestyle planning and is an excellent and brief introduction to passive and index investing.
Dalbar 2015 "Quantitative Analysis of Investor Behavior" (Updated yearly).
Murray, G. and Goldie, D. Learn How to Manage Your Money and Protect Your Financial Future, 2010. Excellent one hour read on active versus passive investing and DFA.
Siegel, J. Stocks for the Long Run, Fourth Edition, 2008.
Sherden, William A. The Fortune Sellers. Wiley, 1998. An amusing and revealing expose of the failure of experts in many fields, including investing, to add value over chance guessing.
Swedroe, Larry E. Winning Investment Strategy. Dutton, 1998 and What Wall Street Doesn't Want You To Know, 2000, St. Martin's. Both these books are easy to read and informative introductions to passive and index investing and DFA style asset allocation models.
Taleb, Nassim The Black Swan, Random House, 2007. A critical examination of the statistical models underpinning modern finance and their limits.