Why active funds usually underperform
Active funds try to beat the market and charge much higher fees for it. Over long periods only a minority manages it, and nobody knows in advance which funds those will be.
Learning objective: After this lesson you can explain why active funds do worse than ETFs on average.
An active fund has a manager who picks stocks. That usually costs one to two percent a year, and sometimes there's also an initial charge of up to five percent when you buy. If Carla invests €10,000, a five percent charge means €500 is gone before her money even starts working.
The Arithmetic Problem
The problem is simple arithmetic. All investors together are the market. Before costs they get exactly the market return between them. After costs they're below it, and whoever pays more is further below.
Few Beat the Index
That's why over long periods only a minority of active funds beat their benchmark index. Over ten years and more that minority gets very small. And the funds that manage it are rarely the same ones as in the decade before.
Advice for Beginners
So you'd have to know today which fund will be among the few winners in twenty years. The past hardly helps. That's why the advice for beginners is usually a broad index.
The core argument comes from Nobel laureate William Sharpe. All actively managed portfolios together make up the market before costs. So the average actively managed euro must do worse after costs than the average passively invested one. That needs no assumption about clever or foolish managers and no particular market phase. It simply follows from the arithmetic.
The SPIVA Data
The data confirm it. S&P's SPIVA reports track this regularly. Over ten to twenty years a clear majority of active funds trail their index in most markets. On top of that, a measurement error makes active funds look better than they are. Funds that did badly and were closed or merged drop out of the statistics. Experts call this survivorship bias. Put them back in and the picture gets worse.
Persistence of Fund Performance
That leaves the question whether good funds stay good. Research finds only weak evidence for it. Part of the excess returns can also be explained by known patterns, for example that small or cheaply valued companies or those with momentum earn a little more on average. You can get such patterns much more cheaply through rules based funds. That doesn't mean every active strategy is bad. But whoever sells one first has to show why this one in particular should succeed.
| Index ETF | Active fund | |
|---|---|---|
| Selection of holdings | tracks the index | a manager picks them |
| Ongoing costs | often 0.05 to 0.3% | commonly 1 to 2% |
| Front-end load | none | up to 5% possible |
| Trading | on-exchange, any time | usually once a day |
| Transparency | holdings visible daily | usually quarterly |
| Goal | match the market return | beat the market |
| Over 10 years | gets the index return | 98% recently fell short of it |
Summary
- Before costs all investors together are the market, after costs they're below it.
- Over ten years and more only a minority of active funds beats its index.
- A fund that did well before won't necessarily do well later.
- Common mistake: buying a fund only because of good results over the last three to five years.
Did you get it?
Why does the argument against active funds follow from arithmetic alone?
Because all active portfolios together make up the market. After costs they must trail it on average.
What is survivorship bias in these statistics?
Closed or merged funds drop out of the figures, which makes active funds look better than they were.
Does the past help you pick a good fund?
Hardly. There's only weak evidence that earlier excess returns continue.
What others often ask about this
Distributing or accumulating?
Before tax they deliver the same. Distributing funds pay out income, accumulating ones reinvest it automatically. The difference is mainly about tax and convenience, and tax rules vary by country.
Aren't active funds better because someone manages them?
On average, no. Over long periods most active funds do worse after costs than their benchmark index. More in the reality check on active funds.
Your task
Compare in the fee calculator, with $20,000 starting capital, a $0 monthly contribution, 7 percent return before costs and 25 years, ongoing costs of 1.5 percent a year against 0.2 percent a year. Write down the difference at the end in dollars. Also work out how many dollars a 5 percent sales charge costs immediately on $10,000.
Sources and further reading
- The SPIVA reports from S&P Dow Jones Indices publish ongoing comparisons of active funds against their benchmarks. View source ↗
Check your understanding
Related
- Active funds against the indexReality Check
- Why saving in a bank account means losing moneyStage 1
- Compound interestStage 1
- Spread, slippage, and liquidityStage 2
- Matching questions for this stageQuestions