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Active vs. Passive Investing: The Results Are In.

Update: Since originally writing this article, the 2009 and 2010 scorecards have been released as well. It’s the same story: Actively managed funds lose.

The results are in: S&P has released their Indices Versus Active Funds Scorecard for year-end 2008.

And guess what? It’s ugly. Active funds got crushed. The passive index benchmark outperformed the majority of active funds in 9 out of 9 equity fund categories (i.e., large cap growth, large cap value, etc.) for the 5-year period ending 12/31/2008.

Now, I freely admit that a 5-year period is shorter than ideal for making comparisons of equity funds. But before we conclude that this is a crazy coincidence, let’s back up a few years and take a look at the scorecards from prior 5-year periods.

  • 2006? Active funds lost in 9/9 categories.
  • 2005? Active funds lost in 9/9 categories.
  • 2004? Active funds lost in 8/9 categories. (50.54% of actively-managed large cap value funds outperformed the index for that period! Go team go!)

I’ll spare you the rest of the years. But the short version is that it’s more of the same.

What about fixed income funds?

I’m glad you asked. A few figures regarding the 5-year period ending 12/31/2008:

  • The passive benchmarks outperformed greater than 90% of actively-managed government bond funds.
  • The passive benchmarks outperformed greater than 90% of actively-managed investment-grade corporate bond funds–with 100% (!) outperformance in both the long-term and short-term categories.
  • The passive benchmark outperformed greater than 95% of actively-managed municipal bond funds.

If that doesn’t make you wary about investing in an actively-managed fixed income fund, I don’t know what will.

Why do most actively-managed funds do so poorly?

Simple: They cost too much. Most active fund managers have to beat their benchmark index by 1-2% per year just to break even on an after-expense basis.

A performance improvement of 2% may sound small. But when we remember that the total stock market’s long-term return is only 8-10%, it starts to become clear why so few funds are able to perform such a feat over any extended period.

Is it possible to beat index funds?

Yes. It’s definitely possible–as evidenced by the fact that the passive benchmark didn’t outperform 100% of actively-managed funds. Of course, it’s also possible to go to a casino, play blackjack for 8 hours and come out ahead. Doesn’t mean we should bet on it.

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  1. Go to a casino, play blackjack for 8 hours and come out ahead! Love the analogy. 🙂

  2. Hey cool, I didn’t know the S&P published that kinda data…
    I prefer using a roulette analogy, just b/c roulete takes all skill from your hands and places it into a hopefully biased wheel 😛

  3. The annualized returns for S&P 500 for the last five year period was -1.89% and even that proved to be too much. Makes me wonder whether anyone should invest in equities at all.

  4. I am prayin for a comment by Rob Bennet! lol

  5. Excellent article. Manages to nicely summarize and update what Vanguard’s Jack Bogle has been saying (with LOTS of long term data to back up his claims) ad nauseum for a long time.

    It’s really amazing how hard it is for active investors to beat the market over the long haul – especially given how virtually EVERY active manager will tell you (and I suspect actually believe it in many cases) that THEY will handily outperform “the market”. It’s like the concepts of expenses and average just overwhelm our intuitive view of the world. (If it weren’t for all the evidence, I probably would refuse to believe it).

    The icing on the cake is how, since the crash, virtually everyone with a vested interest in active management frequently repeats the mantra “passive management is dead – the S&P 500 has negative returns over the past 10 years” – failing to cite fully audited statistics on how THEY did over the same period, of course!

    Kudos on your site, your outlook, and your writing style – refreshingly straightforward.

  6. This article is short-sighted. Of course active management under-performed passive investing after the worst financial crisis since the Great Depression. Fixed income is a good example because only Treasuries had positive performance in 2008. Active managers are paid for their research capabilities, so of course they tend to own more non-Treasury securities than a passive fund. There will always be periods when active does better and periods when passive outperforms. Ultimately, it is up to the investor to decide what is best for them based on the market environment.

  7. Gibby, you say that “there will always be periods when active does better and periods when passive outperforms.” Please name a period in which the majority of actively managed funds outperformed their passive benchmarks.

    I encourage you to check out the above-linked reports for the prior several years. Even during the bull market leading up to ’08, most active funds were beaten by their low-cost, passive counterparts.

  8. @Mike – Let me start by saying that I agree with the overwhelming majority of what I’ve read from your blog.

    We somewhat part ways on this post because the active vs. passive discussion should never be taken simply as average returns or percentiles of which strategy did better. Investment style MUST be considered in this analysis as depending upon the style used, returns follow different peaks and troughs.

    Case in point is that during the 1990s, anything on the growth side of the spectrum outperformed the S&P 500 with growth at any price managers destroying the index. From 2000 through 2002, anything value outperformed the S&P 500 index with deep value funds (like Clipper before their top manager left) beating the index by double digits annually.

    In addition, if we expand beyond these extreme cycles, the long haul suggests that there are plenty of capable managers that consistently beat the index over long periods of time (10, 15, 20 years). There are also a great many managers that underperform due to both ineptitude AND investment strategies that are NOT designed to beat the S&P 500.

    As an example, many large (not mega) banks offer mutual funds that are extensions of their private banking group’s investment philosophy. These funds are designed to create returns that are above bonds, but have less risk – typically focused on higher dividend paying issues including preferred stocks. However, these funds are often classified (and rightly so) as large cap blend or large cap value equity mutual funds, but they do not have a mandate of beating the market.

    All I want to point out is that the stats you and many other passive investors use are skewed to appear as if the task of outperformance is impossible. It IS possible and it DOES happen with regularity, but you have to find the good managers.

    If you’re screening for these on a website like Morningstar or your investment provider, just start with one screen: manager tenure > 10 years. This eliminates a huge number of the funds out there today and with it goes a lot of the bottom performers.

    Of course, passive investing is definitely right for anyone that doesn’t want to put in the kind of research needed to find quality managers, monitor their performance, and make the tough decisions of when to let one go. Generally, I like passive investing for the majority of people the majority of the time, but I wouldn’t want someone who has an interest in active management to be discouraged based on the stats presented in this post.

    Smart Money had an article on 100 battle tested mutual fund managers earlier this year and I’ve used many of these funds for myself and clients over the years. It’s a great list to get started with research.

  9. In reply to Michael:

    “Case in point is that during the 1990s, anything on the growth side of the spectrum outperformed the S&P 500 with growth at any price managers destroying the index. From 2000 through 2002, anything value outperformed the S&P 500 index with deep value funds (like Clipper before their top manager left) beating the index by double digits annually.”

    If you take a look at the linked-to study, you’ll see that it accounts for this. Large cap growth funds are compared to a large-cap growth index, mid-cap value funds are compared to a mid-cap value index, etc. Still, in 9/9 categories, less than half the funds outperformed their benchmark. And if you look at prior years, it’s clear that it’s not an anomaly.

    “All I want to point out is that the stats you and many other passive investors use are skewed to appear as if the task of outperformance is impossible.”

    I absolutely agree that it is possible. (That’s why I said exactly that in the conclusion of the article.) But the evidence repeatedly shows that it’s unlikely.

  10. @Mike – The S&P Barra Growth Index remains a poorly fit index to growth at any price funds. The same is true on the value side of things. Even if you use these ‘closer’ fit indices, the numbers for deep value and gaap remain markedly higher during these time periods.

    To put it another way, if you use 5 year increments to measure these things, you will see entirely different ends of the spectrum depending on the overall market cycle. The 10% or whatever the % may be for a given year that outperform the index will be filled with different names. In 1999, they were names like Janus or Putnam (growth at any price funds). In 2002, they were names like Clipper or Lord Abbett (deep value funds). In 2008, you’d see names like Leuthold or Ivy (go anywhere funds).

    If you expand this from 5 years to 15 years, you’ll see that many of the best fund managers, regardless of styles, rise above their ‘best fit’ benchmarks. Those that employ active managers don’t simply buy the average actively managed mutual fund, but they do some homework and try to pick the funds that they believe will perform well. Getting rid of the garbage managers is easy enough through setting a 10 year minimum tenure requirement.

    I’d love to see a study of managers with 10 years experience on the same fund versus the indices. I bet the numbers in the study quoted would shift dramatically.

    By the way, let’s say that it is 9 out of 10 funds that underperform their index. This means that there are nearly 2000 funds each year that do it better than the index. Again, not criticizing passive investing, simply pointing out that this study isn’t close to conclusive evidence that active investing doesn’t work.

    To your point that “the evidence repeatedly shows that it’s unlikely”, this just means that if you randomly selected a portfolio, you would be unlikely to build an actively managed portfolio that would outperform. It does not preclude the possibility of using effective selection methods that would change the odds in the active portfolio’s favor.

    If I have the time, I’ll do the 10 year comparisons.

  11. Michael: Have you seen the FRC’s study “Predicting Mutual Fund Performance II” indicating that:

    1. expense ratio is the only statistically reliable indicator of future performance, and that
    2. every other potential predictor they analyzed (including manager tenure) was not statistically more useful than guessing randomly?

    I’d be interested in hearing your thoughts.

  12. @Mike – I dropped you an email, but wanted to point out something that you are already aware of – there is no way to predict future performance. While passive investing can predict relative performance (it’s kind of rigged to be that way), this doesn’t do anything for absolute performance. The FRC study didn’t add any new value to what was already well known – fund flows are negatively correlated to improved performance, investors chase returns, fund expenses always reduce performance, and there is no way to see the future.

    That said, the study is important in bringing these elements together and reiterating these facts.

    As to predicting future performance of actively managed mutual funds, of course there is no guarantee of being able to guess right, but even though the study didn’t find statistically significant relationships between tenure, M* ratings and the like, you can’t fight the fact that many active managers have, do, and will continue to outperform the indices. Just because we can’t predict it, it doesn’t mean that this investment strategy should be taken off the table.

  13. “Just because we can’t predict it, it doesn’t mean that this investment strategy should be taken off the table.”

    It seems to me that’s precisely what it means. If it’s impossible to predict which fund managers will outperform, should we really attempt to do so?

  14. @Mike – I’m glad you pointed this out. As an entrepreneur, the odds of my business being successful and being passed on to my grandchildren are…well…not good. Even in the face of odds that are far worse than investing successfully in the stock market AND the considerably more unpredictable returns on a small business, it doesn’t mean I or anyone else shouldn’t pursue it. What would happen if there were no people starting new businesses or taking risks with unpredictable outcomes?

    Certainly I’m taking measures that are believed to increase the odds of success (just as active managers do), but I also recognize there is no guarantee waiting on the other side (just as active managers do). I’m just sayin’ be open about these things. It’s great to steer people down the road with relatively good odds, but don’t shut down if there are other paths to the same destination.

    By the way, we haven’t covered the risk or psychological aspects of the asset allocation discussion. Perhaps sometime down the road?

    Seriously…love the blog and great discussion.

  15. Regarding your self-employment analogy: Presumably running your business has some emotional/psychological benefits as well, yes? Mine sure does. If it didn’t, and if the financial expected return were lower than that of having a job, I’d say you and I made poor choices by becoming self-employed.

    As I’ve mentioned before (in, for example, this post, this post, and the comments to this post) I have no problems with other people pursuing other investment strategies. My complaint is with the entire industry built around convincing people that their odds with such strategies are better than they really are.

  16. @Mike – last comment. You are exactly right. I commented on another post you have about what a financial advisor should be doing. In part, the remainder of my life will be spent eliminating salespeople who profess to be ‘advisors’. Also, as your Motley Fool post so effectively points out, there is far too much peddling to the quick buck. It simply doesn’t exist…well, not the way they would have you believe anyway.

    You run a terrific blog and I’m glad to see that you can articulate your points so effectively. By the way, I haven’t collected a paycheck in more than a year and a half, so the non-monetary benefits are worth it.

  17. Susan Tiner says

    I basically agree with the point that most actively managed funds perform poorly because they cost too much, but as Dan Wiener likes to say, low-cost funds with great managers can and do outperform their indexing benchmarks.

    For example,
    madsinger’s latest monthly report at

    shows results for a selection of portfolios over different periods of time, up to 10 years. The actively managed Newsletter Growth (Dan Wiener) portfolio has done well over a 10 yr period.

  18. Dan Cuprill says

    Aside from costs, active management fails because it relies on receiving information before anyone else Assuming we all act legally, this is simply not possible. Past success at defeating market averages fall under the law of large numbers: if enough people try to do something, someone will succeed, even if it was only by luck. Have 100 people flip coins. I guarantee that someone will flip heads ten times in a row. In coin flipping, we call it luck. But in the world of finance, we call it genius. It’s not.

  19. Guess I must be one of the lucky monkeys on coin-flip island. My active funds easily beat the averages after taxes for the past 10 years….. all of them. I do own indexes in my portfolio (about 50/50 between indexes and active), but in this tin decade they haven’t beaten my actively managed funds.

  20. Congratulate the Biz of Life. You certainly has beaten the odds.

    It is simple arithmetic that active investing on aggregate can not beat passive investment. Passive investors hold the market portfolio, active investors jump around, but on aggregate they must also hold the market portfolio. So before costs, they must have the same return. After costs, you know the answer.

    There is a way for an active investor to beat the market, however. He must pick a skillful manager BEFORE the manager has established a track record of skill. Once he has established the track record, he will extract all the excess returns of his skill. And why shouldn’t he, his skill is the scarce resource, not the investor’s money.

  21. Great post and discussion. Here’s a couple of side points for those trying to pick the winners:
    -the largest pension funds in the country with their full-time staffs put almost one-third of their investable assets in low cost indexed funds
    -think about Long-Term Capital Management, Bear Stearns, Lehman Brothers, Bill Miller
    All have/had contacts and information you and I could only dream about.

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