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One of the most difficult decisions investors face is whether to be active or passive.
Collectively, passive investors earn higher returns.
That is, the average passive investor earns more than his active counterpart.
However, a small portion of active investors obtain alluringly high returns that can be hard to ignore.
We’ll discuss this active versus passive dilemma below.
What’s the difference between active and passive investing?
A passive investor buys a set of assets, typically in amounts specified by an index, and holds them for years.
She does not try to time the market or project whether Apple or Google shares will perform best.
An active investor picks individual assets, say shares of Apple, Amazon, and / or Starbucks.
She may sell them whenever she believes she has found a better investment (sometimes daily).
A passive investor typically uses index funds like
SPY
that track an index like the S&P 500.
An active investor may perform frequent trades herself or buy a fund like
JEPI
whose manager(s) make the active trading decisions for her.
A simple fact
Active investors collectively earn lower returns than passive investors.
This is not an opinion or observation, it’s a mathematical fact.
In 2022 the S&P 500 returned -18.1%, so passive investors earned -18.1%, before fees.
What did the remaining participants—the active investors—earn?
If it was any more or less than -18.1%, then the S&P would’ve returned more or less and -18.1%.
Active investors collectively earned -18.1% as well, before fees.
The only difference is that active investors pay higher fees.
If that wasn’t clear, consider an analogy.
A class scores an average of 70 on an exam.
If you remove the kids who scored exactly 70, what is the average score from the rest of the class?
It’s still 70!
If you read an article saying “this may be a good time for active investing” you can have a chuckle.
It doesn’t matter what time they are speaking of, active investors collectively earn subpar returns.
Of course, some active investors will earn more than passive investors.
It may be tempting to think you can join this group, but check out the observations below before jumping to this conclusion.
Observations
How many active investors outperform?
Since active investors collectively earn the market return, you may expect about half of them to beat the market
(less than half after accounting for fees).
This has been studied extensively for different time periods, different markets, regions, ….
A good source of such data is
SPIVA.
In any given year, roughly 30-45% of professional money managers outperform their market index / benchmark.
There’s another interesting fact in this data.
If investing were mostly skill-based, like basketball or tennis, you’d expect winners to continue outperforming every year.
After all, an NBA player that would destroy us in basketball today would most likely destroy us again tomorrow, next year, ….
Historical data indicates that investing success is more luck than skill.
Percentage of active managers that beat their benchmark
| Index |
1-year [%] |
3-year [%] |
10-year [%] |
| S&P Composite 1500 |
42 |
18 |
14 |
| S&P MidCap 400 |
45 |
17 |
7 |
Take a look at the table above.
About 42% of active investors outperform the S&P composite over 1 year.
If these are “skilled” investors, most of them would outperform over 3 years as well
(nearly 42%).
However, less than 18% outperform the index over 3 years!
There’s a good chance a manager / fund that outperformed before won’t continue to do so.
There’s a lot of luck in investing!
The observation above is not unique to that index or time period, it’s more or less true for all the indexes and times studied.
As you might expect from the observations above, few managers / funds outperform over the long-term.
For most indexes and periods, about 10% outperform over 10 years.
This suggests that a small number of managers do have "skill"—if it were completely random we’d expect
less than 1% to outperform over 10 years.
However, when there’s an indication that a manager has “talent” for this, his fund will likely jack up the fees to the extent that
the net return is again not likely to beat the index.
A recent report from S&P Global found that over the 20 years from 1/1/2003 to 12/31/2022,
about
3% of domestic funds beat their benchmark.
How many stocks outperform?
Here’s another interesting observation.
If you selected a stock at random, you might expect a 50% chance of outperforming an index in which the stock belongs.
In other words, half the stocks earn a higher return than average, and half lower.
Unfortunately, this is not what historical data shows!
Only 253 of the 975 stocks in the S&P 500 from 2002-2021 beat the average.
Hence, a stock picked at random would only have a 25% chance of beating the market!
A small number of stocks perform very well and push up the average (mean).
Wages are the same way—the
average American earned
$58k in 2021, yet only 30% earned more (50% will always be above / below the median, which in this case was $37k).
It’s not just the S&P 500, this is a general phenomena for equity indexes—a small number
of high performers account for an unusually large portion of the total return.
For example, it’s not uncommon for 1-2% of the stocks in an index to generate over 33% of the returns.
This means you’re more likely to get a subpar return by picking a small number of stocks at random, compared to owning the index.
Fees
As we discussed, passive and active investors earn the same returns collectively, before fees.
The difference in returns is due to fees.
The latest estimates I’ve seen are about 0.06% for passive funds and 0.7% for active funds.
While these fees have shrunk, studies indicate that most people underestimate the impact of fees.
If you think fees are negligible, I recommend reading Investment Fees: What and why to avoid.
Why is active investing more costly?
Costs go up with each trade made, even if there’s no explicit “trading fee.”
- Either you or your active fund manager(s) do research to determine what to buy/sell.
- In the case of an active fund manager, fees must pay her (often lofty) salary, benefits, support personnel, ….
- Buying / selling often triggers capital gains taxes which can subtract up to 37% of your gains.
- Even without explicit “trading fees” you (or the fund’s traders) have to contend with a
spread which
will cause you to pay more and sell for less. This is more penalizing the more of an asset you want to buy / sell.
Conclusion
Passive and active investors earn the same returns collectively, before fees.
Active investors pay more fees and hence achieve lower net returns on average.
While active investing provides an opportunity for outsized returns, they’re difficult to achieve, particularly over the long haul.
About 10% of active fund managers beat their benchmark over 10 years, and 3% over 20 years.
While skill is relevant, the data indicates that luck plays a substantial role in active investing.
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