Do active funds outperform passive funds?
Passive investing, which tracks a specific index, is designed to match, but not beat, the market performance. On the other hand, active investing has the potential to outperform the market. But herein lies the issue with the data that show passive outperforming active: Not all active management is genuinely active.
While passive funds still dominate overall due to lower fees, some investors are willing to put up with the higher fees in exchange for the expertise of an active manager to help guide them amid all the volatility or wild market price fluctuations.
Active funds generally have higher expense ratios due to the extensive research, analysis, and management activities performed by the fund manager. On the other hand, passive funds have lower expense ratios because the fund manager's role is limited, and the investment strategy is relatively straightforward.
Index funds seek market-average returns, while active mutual funds try to outperform the market. Active mutual funds typically have higher fees than index funds. Index fund performance is relatively predictable; active mutual fund performance tends to be less so.
More than half of active funds and ETFs, 57%, outperformed their passive counterparts in the year from July 1, 2022, through June 30, 2023, an improvement from the 43% that did so the previous year, according to a new report from Morningstar.
Over a third of active funds outperformed their passive counterparts in 2023, an uptick of nine percentage points from last year's 27%, according to AJ Bell's 'Manager versus Machine' report.
“Active” Advantages
Active management includes mutual funds and exchange-traded funds, as well as portfolios of stocks, bonds and other holdings managed by financial advisers. Among the benefits they see: Flexibility – because active managers, unlike passive ones, are not required to hold specific stocks or bonds.
Passive investing targets strong returns in the long term by minimizing the amount of buying and selling, but it is unlikely to beat the market and result in outsized returns in the short term. Active investment can bring those bigger returns, but it also comes with greater risks than passive investment.
The downside of passive investing is there is no intention to outperform the market. The fund's performance should match the index, whether it rises or falls.
Disadvantages of Active Management
Actively managed funds generally have higher fees and are less tax-efficient than passively managed funds.
Which funds consistently beat the S&P 500?
| Fund | 2023 performance (%) | 5yr performance (%) |
|---|---|---|
| MS INVF US Growth | 49.29 | 62.08 |
| New Capital US Growth | 48.68 | N/A |
| T. Rowe Price US Large Cap Growth Equity Fund | 48.64 | 98.92 |
| Baillie Gifford Worldwide US Equity Growth | 46.58 | N/A |
Although it is very difficult, the market can be beaten. Every year, some managers boast better numbers than the market indices. A small fraction even manages to do so over a longer period. Over the horizon of the last 20 years, less than 10% of U.S. actively managed funds have beaten the market.
For large cap stocks, there are funds that have beaten S&P500 consistently for over 40-50 years. Fidelity's Contrafund has beaten the market since inception in the 60s. Fidelity growth company and blue chip growth since the 80s. American century's large cap funds (TWCIX, TWCGX, TWCUX) since 70s.
| Ticker | Name | 5-year return (%) |
|---|---|---|
| STSEX | BlackRock Exchange BlackRock | 16.47% |
| USBOX | Pear Tree Quality Ordinary | 16.38% |
| PBFDX | Payson Total Return | 16.30% |
| SSAQX | State Street US Core Equity Fund | 16.20% |
Active funds aim to outperform their benchmark by relying on a fund manager making individual investment choices. Active funds have fund managers. Active funds have fund managers who use their expertise and large amounts of research to decide which investments the fund will hold.
Since you hold investments for different periods of time, the best way to compare their performance is by looking at their annualized percent return. In this example, your annualized return is 9.42 percent. Tip: Use FINRA's Fund Analyzer to find annual and total return for mutual funds and ETFs.
Over the full period, just 2% of actively managed Large-Cap Core funds beat the S&P 500. Even in categories such as small- and mid-sized stocks, and growth — which benefited from the tailwinds of an outperforming universe — a minimum of 81% of actively managed funds underperformed the benchmark.
The long-term performance data show active management has a lot of catching up to do. Over the past 10 years, less than 7% of U.S. active equity funds have beaten the market, according to the Spiva U.S. scorecard .
In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons. Only one out of every four active funds topped the average of their passive rivals over the 10-year period ended December 2022.
Key Takeaways. Active risk arises from actively managed portfolios, such as those of mutual funds or hedge funds, as it seeks to beat its benchmark. Specifically, active risk is the difference between the managed portfolio's return less the benchmark return over some time period.
Do active managers beat the market?
The answer might not be as straightforward as it seems. According to extensive research, a staggering 94% of active fund managers do not beat the market.
The potential benefits of an active investment strategy are: A chance at bigger rewards. An actively managed fund or portfolio has the potential to beat index returns. A quality investment strategy can be an important factor in capturing greater risk-adjusted returns relative to the market.
Warren Buffett is the ultimate example of the active investor. He believes in identifying quality stocks with deep value and holding them to eternity (well almost).
The challenge is that as investors recognize a manager's skill, they place more assets under his management. Those additional assets make it harder for the manager to achieve the same level of performance—among other reasons, because the bigger a fund is, the more likely it is to move prices.
Passive investing tends to perform better
Despite the fact that they put a lot of effort into it, the vast majority of of active fund managers underperform the market benchmark they're trying to beat. Even when actively managed funds do experience a period of outperformance, it doesn't tend to last long.
