The case for passive investing in a nutshell

One of the most talked about issues in the financial media is whether you should actively or passively invest. Active funds try to beat the market by picking the right stocks; passive funds, or index funds, simply track the whole market.

It’s often billed as the active versus passive “debate”, but it’s not really a debate at all. For the vast majority of investors, passive is definitely the way to go.

Why? Well, it’s basically down to simple mathematical points.

A zero-sum game

The first mathematical point is about averages and markets. Active funds and passive funds are investing in the same markets but in different ways. Unfortunately, each market is a zero-sum game so for one active manager to win, another must lose.

Active managers aim to be better than average — to beat the market return. Some will, some won’t, while others will hover around the average return. The problem is, they all charge fulsome fees. Active management is not cheap and almost without exception, you pay the fees regardless of how well or badly managers perform.

Crucially, though, it’s very hard to tell, in advance, which camp your chosen manager will turn out to be in. Of course, they will claim to be able to beat the market, but, by the law of averages, it’s just as likely that they won’t.

An argument we often hear from advocates of active management is that when the market falls, so does the value of your index fund. Active managers, on the other hand, have the flexibility to limit your losses. In theory, that’s right: they do have the potential to limit the damage. What they don’t tell you is that, in practice, they’re very bad at predicting when the market is about to fall, or that, in a falling market, active funds often fall further than the broader index.

Nor do they tell you that by reducing their risk exposure in anticipation of a crash that never comes, they tend to lose out to index funds when markets suddenly rise, too. Again, it comes down to averages. No active manager likes to admit being below average, but half of them have to be.

The cost difference

The second piece of simple arithmetic underpinning the case for low-cost indexing is explained by the Nobel Prize-winning economist William Sharpe in his 1991 paper, The Arithmetic of Active Management.

Here’s a brief summary:

The investing community is divided into active and passive investors.
Before fees, the return on any average actively managed pound of shares in ‘Company ABC’ will be exactly the same as the return on the average passively managed pound in the same company.
Active investors are people who need salaries, support teams, research and marketing, and so they charge higher fees.
After fees, the return on the average actively managed pound in ‘Company ABC’ will be less than the return on the average passively managed pound.

Therefore, the average active investor must underperform the average passive investor. To quote Professor Sharpe: “These assertions will hold for any time period (and) depend only on the laws of addition, subtraction, multiplication and division.’”

We should also point out that we’re not talking here about minor differences in cost. Once you factor in all the different fees and charges, active investors are typically paying in the region of FIVE times more to invest than their passive peers.

As Jack Bogle, the founder of Vanguard, said, it all boils down to “the relentless rules of humble arithmetic” — a phrase he used for the title of a 2005 paper for The Financial Analysts Journal. In it, he says: “The overarching reality is simple: gross returns in the financial markets minus the costs of financial intermediation equal the net returns actually delivered to investors.”

The evidence against active

So, we’ve looked at the mathematical basis for avoiding active funds. What about the evidence that active management is a loser’s game in practice?

There is, in fact, so much data to prove the point that it’s hard to know where to start, but we’re going to point out three very strong sources of evidence.

The first is the SPIVA scorecard run by S&P Dow Jones Indices, which compares actively managed funds all over the world against their appropriate benchmarks on a semiannual basis. It consistently shows that:

most funds underperform for most of the time;

any outperformance tends to be short-lived;

a fund’s performance generally deteriorates over time; and

active managers fail time and again to take advantage of periods of market volatility like the ones we saw in the first half of 2020 and 2022.

The second source of evidence is the Active/ Passive Barometer run by Morningstar, which tells a very similar story to SPIVA. It surveys 30,000 funds, bundled up into categories to make comparisons fair and easy. Of the 54 actively managed categories they monitor, just five categories have beaten the market over ten years. Most beat the market less than 25 per cent of the time.

The third source we would draw your attention to is an ongoing study led by David Blake at The Pensions Institute in London. The authors have looked at 516 active equity funds over a 17-year timescale. According to their analysis, around 99 per cent of all equity mutual fund managers were unable to deliver outperformance from stock selection or market timing.

Somewhat devastatingly, they added a final flourish: “Just one per cent of fund managers actually prove to be ‘stars’, being able to generate superior performance in excess of operating and trading costs. However, they extract all of this for themselves via fees, leaving nothing for investors.”

In other words, even if you were skillful or likely lucky enough to identify a genuine star in advance, you would still have been better off in an index fund once your costs are factored in.

It’s a no-brainer

In conclusion, then, the choice between active and passive is a no-brainer.

Will actively managed funds ever be worth investing in? Possibly. But only if they substantially reduce their fees and charges. And will that happen? Don’t hold your breath. Managing another people’s money is an awesomely lucrative business. Fund managers won’t want to give that up at any time soon.