The case for active management used to be the obvious one. Skilled professionals, paid to research companies full-time, ought to beat a passive basket of stocks that includes both winners and losers. For most of the twentieth century, that assumption went largely unchallenged. The numbers that have accumulated since the 1970s tell a different story. Across nearly every asset class, time period, and geography studied, the majority of actively managed funds underperform comparable index funds after fees. The S&P Indices Versus Active (SPIVA) scorecard, published twice a year by S&P Dow Jones Indices, has documented this gap consistently for two decades. The question for new investors is no longer whether index funds are competitive with active management; it is whether there is any reliable reason to choose active management at all.
What is the difference between the two approaches?
An index fund holds the securities in a published index, such as the S&P 500 or the total U.S. bond market, in roughly the same proportions as the index itself. There is no portfolio manager making decisions about which stocks to buy or sell; the rules of the index determine the holdings. Operating costs are correspondingly low.
An actively managed fund employs a portfolio manager and analysts who select securities based on research, valuation models, and market views. The goal is to outperform a benchmark, typically a comparable index. Operating costs are correspondingly higher, because someone has to pay the salaries of the research staff and trading desk. Our explainer on what an index fund is walks through the mechanics in more detail.
How wide is the performance gap?
The most recent SPIVA U.S. scorecard, covering the 20 years ending December 2021, found that 95% of actively managed large-cap funds underperformed the S&P 500. In mid-cap and small-cap categories, the figures were 95% and 94% respectively. International and emerging-market funds fared slightly better, but the underperformance was still the rule, not the exception.
The pattern holds outside the United States. SPIVA scorecards for Europe, Canada, Australia, and Japan all show that more than 70% of active funds underperform their benchmarks over 10-year periods. The gap is structural, not regional.
A 2020 study by Morningstar, which examined more than 4,400 active funds across 20 categories, found that only 23% beat their average passive peer over the previous decade. Even that figure overstates active success, because the 23% includes survivorship bias: funds that closed due to poor performance dropped out of the sample.
Why do active funds struggle to beat the index?
Three forces work against active managers. The first is fees. According to the Investment Company Institute, the asset-weighted average expense ratio for actively managed equity funds in 2021 was 0.68%, compared with 0.06% for equity index funds. A 0.62-percentage-point annual headwind compounds significantly. Over 30 years, it reduces a $100,000 investment by roughly $130,000 in foregone returns, assuming an 8% gross annual return.
The second is the arithmetic of markets, articulated by Nobel laureate William Sharpe in his 1991 paper “The Arithmetic of Active Management.” Sharpe pointed out that the average actively managed dollar must, by definition, earn the market return before costs and less than the market return after costs. Active management as a category cannot beat the market; some active managers can only outperform at the expense of other active managers.
The third is the difficulty of identifying skill in advance. Past performance, despite the warning on every prospectus, is the most common way investors choose active funds. The evidence that past outperformance predicts future outperformance is weak. The Morningstar Persistence Scorecard regularly finds that fewer than 10% of top-quartile funds remain in the top quartile five years later.
Are there situations where active management makes sense?
The evidence offers a few narrow cases. In some less-efficient markets, such as small-cap emerging market equities or certain segments of high-yield bonds, active managers have historically captured a slightly higher proportion of outperformance. Even there, the majority still underperforms, but the gap is smaller than in large-cap U.S. equities.
In municipal bonds and certain tax-managed strategies, active management can add value by harvesting tax losses and navigating credit-quality differences that an index fund cannot. Investors in high tax brackets sometimes use active municipal bond funds for this reason.
Outside of these specific niches, the long-term data make a difficult case for active management. The exceptions are real but small.
What about the famous outperformers?
Every investor has heard of Peter Lynch’s Magellan Fund, which returned 29% annualized from 1977 to 1990, or Bill Miller’s Legg Mason Value Trust, which beat the S&P 500 for 15 consecutive years through 2005. These records are real and unusual. They are also a small sample drawn from many thousands of funds, which is roughly what statistical chance would predict.
A 2010 study by Eugene Fama and Kenneth French, using a 22-year sample of U.S. equity funds, concluded that the distribution of fund manager performance was statistically indistinguishable from what would be expected if no managers had any skill at all. A few outliers existed, but identifying them in advance, before they outperformed, was effectively impossible.
The Magellan Fund’s record after Lynch’s retirement and the Legg Mason fund’s collapse during the 2008 financial crisis both illustrate the underlying lesson: the star manager often leaves, retires, or has a bad decade, and the investor who chased the prior record bears the consequences.
How does fund cost compound over time?
Cost is the most reliable predictor of future fund performance. Morningstar’s research has found that the expense ratio is a stronger predictor of relative returns than any other single fund characteristic, including past performance, star rating, or manager tenure.
Consider an investor contributing $500 per month for 30 years to two funds with identical gross returns of 8%. The index fund charges 0.05%; the active fund charges 0.75%. After 30 years, the index fund balance is roughly $725,000. The active fund balance is roughly $655,000. The $70,000 difference is not the result of underperformance; it is the result of fees alone.
This is one reason index funds anchor most of the portfolios in our guide to building an investment portfolio from scratch. Reducing costs is one of the few investment decisions that can be made with high confidence in advance.
What is the practical takeaway?
For most investors, the durable choice is a portfolio of low-cost index funds covering U.S. stocks, international stocks, and bonds. The configuration is dull, transparent, and supported by the largest body of evidence in modern finance. Investors who want to allocate a small portion of their portfolio, perhaps 5% to 10%, to actively managed funds or individual stocks for personal interest can do so without disrupting the overall plan. The mistake is making active management the core of a long-term portfolio.
David Swensen, who managed the Yale endowment from 1985 until his death in 2021, captured the practical point in his 2005 book Unconventional Success: “A small minority of investors succeed in active management. The rest should index.” Two decades of additional data have not undermined the conclusion.
Frequently Asked Questions
What is an expense ratio?
An expense ratio is the annual fee a fund charges, expressed as a percentage of assets under management. A fund with a 0.50% expense ratio costs $50 per year on every $10,000 invested. The fee is deducted automatically from the fund’s returns, so investors never see a bill, but the impact on long-term performance is substantial. Index fund expense ratios typically range from 0.03% to 0.20%; active fund expense ratios commonly range from 0.50% to 1.25%.
Do ETFs count as index funds?
Most ETFs are index funds in a different legal wrapper. They track a published index, hold the underlying securities in roughly the same proportions, and charge very low fees. There are actively managed ETFs as well, but they remain a minority of total ETF assets. The structural differences between ETFs and mutual funds, including intraday trading and tax efficiency, are practical rather than philosophical.
Are target-date funds active or passive?
Target-date funds can be either, depending on the provider. Vanguard’s, Schwab’s, and Fidelity’s index-based target-date funds use underlying index funds and charge very low fees, typically 0.08% to 0.15%. Active target-date funds from some providers charge 0.50% or more. The label “target-date fund” describes the glide path, not the underlying management style.
What if my 401(k) only offers active funds?
Many older 401(k) plans still default to active funds, but most have added at least one low-cost index option, often labeled as an S&P 500 or total stock market fund. If the plan offers no index options, an employee can contribute enough to capture the employer match, then direct additional retirement savings to a low-cost IRA. The 401(k) options can also be raised with the plan administrator; employee feedback has driven many plans to add index funds over the past decade.
Should I sell my active funds now?
The answer depends on whether the funds are held in taxable or tax-deferred accounts. In a tax-deferred account such as an IRA or 401(k), switching from active to index funds carries no tax consequence. In a taxable account, selling a fund with embedded gains triggers capital gains tax, which may make a gradual transition more efficient. Stopping new contributions to the active fund while letting existing shares ride is one common approach.
Are index funds risky during market crashes?
Index funds are no riskier than the markets they track. An S&P 500 index fund will fall when the S&P 500 falls. The same is true of active large-cap funds, which on average fall about as much as the index during downturns despite the goal of providing downside protection. SPIVA data show that active funds outperformed in only 39% of bear markets since 1990, despite the common marketing claim that active management adds value when markets are turbulent.