Active management: what the evidence says

The debate between active and passive management is frequently framed as a matter of opinion, and a substantial body of evidence exists.

The arithmetic first

Which is not empirical but definitional.

All investors collectively hold the market, so the aggregate return before costs is the market return.

Passive investors earn the market return minus low costs.

Therefore active investors collectively must earn the market return minus their higher costs.

Which means that in aggregate, active management must underperform passive by the difference in costs, before any question of skill arises.

This is a matter of arithmetic rather than of evidence, and it sets the bar that individual active managers must clear.

What the studies find

Consistently across markets and periods.

Regular reports comparing active funds against their benchmarks find that a majority underperform over periods of several years, with the proportion underperforming generally rising with the length of the period examined.

Over fifteen and twenty year periods, the proportion outperforming is small in most categories.

Survivorship bias makes the raw picture look better than it is, since funds that perform poorly are closed or merged and disappear from the comparison — studies adjusting for this find worse results.

And the results hold across geographies, asset classes and time periods, with some variation in categories where markets are less efficient.

Persistence

The practical question for anyone selecting funds.

Even if some managers have skill, identifying them in advance requires that past performance predicts future performance.

Studies of persistence generally find weak evidence: funds in the top quartile of performance in one period are not reliably in the top quartile in the next, and the distribution of subsequent performance resembles chance in many analyses.

Which means selecting on past performance — which is how most retail fund selection happens — has limited basis.

Regulatory warnings that past performance does not indicate future returns exist for this reason.

Why some managers do outperform

For balance.

Some do, over meaningful periods, and distinguishing skill from luck requires long records and careful analysis.

The conditions that appear to help: genuinely differentiated portfolios rather than benchmark-hugging; lower costs; capacity constraints, since large funds find it harder; manager investment in their own fund; and stable, patient capital that does not force selling.

Less efficient market segments — smaller companies, some emerging markets, some fixed income sectors — show somewhat better active results in various studies, though not uniformly.

Closet indexing

A specific problem.

Some funds charging active fees hold portfolios closely resembling their benchmark, which guarantees underperformance by roughly the fee.

Regulators in several jurisdictions have investigated this and required disclosure or taken enforcement action.

Active share — a measure of how much a portfolio differs from its benchmark — is a useful check, and a fund with high fees and low active share is straightforwardly poor value.

What this means practically

A defensible position.

Use low-cost broad index funds for core exposure, where the evidence is strongest and the arithmetic is favourable.

If using active management, do so deliberately: for a specific reason, in a segment where the case is stronger, at a reasonable cost, with a genuinely differentiated portfolio, and with an expectation of periods of underperformance.

Do not select on recent performance.

Do not hold many active funds, since collectively they approximate an expensive index.

And recognise that the decision is about probability rather than certainty — some active funds will outperform, and identifying them in advance is the difficulty.

The counterarguments

Taken seriously.

If everyone indexed, price discovery would suffer — which is true in principle and remote in practice given the volume of active trading that remains.

Index funds concentrate ownership among a small number of large managers, raising governance questions that are genuine and are separate from the investment case.

Market-cap weighting produces concentration in the largest companies, which is a real characteristic and worth understanding.

And indices are constructed by providers making decisions, which means indexing is not entirely passive.

None of these change the cost arithmetic for an individual investor.

The reasonable conclusion

Stated plainly.

The evidence supports low-cost broad index funds as a default for most investors.

It does not prove that active management is worthless, and it does place the burden on any active fund to justify its cost.

And the more consequential decisions for most people — how much to contribute, what allocation to hold, whether to interfere — sit upstream of this question entirely.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.