Why Your Passive Fund Is Crushing Active Managers

Passive and active fund managers have heatedly debated which investment approach works best as $1.2 trillion has poured out of active stock funds and into passive funds since 2007. A new study seems to settle the debate and deals a blow to active stock funds. According to a detailed story in the Wall Street Journal, some 82% of all active U.S. funds trailed their respective benchmarks over the last 15 years, citing a report from the S&P Indices Versus Active (SPIVA) funds scorecard. This was the first year that the analysis included 15 years of data, helping smooth out periods of volatility that can affect the performance of active managers.

Most striking, the study shows that small cap, mid cap and large passive funds have drastically outperformed their active peers over 5, 10, and 15 year periods. The detailed report, chock full of hard data, deals a setback to active managers as a group, many of whom have argued that they do well when results are averaged out over a long period. (For more, see: What's the Difference Between Passive and Active Portfolio Management.)

Active management entails a portfolio manager who analyzes the market and pick stocks that are meant to outperform. These managers traditionally have touted their ability to make accurate calls and "beat the market" on a regular basis. As a result of those claims, many active managers are able to charge investors hefty fees to pay their salaries as well as cover the transaction costs associated with frequent buying and selling. The latest numbers, though, suggest that most people would have been better off investing in a much cheaper passive fund. A passive fund is composed to track its benchmark (for example a large-cap fund might be benchmarked against the S&P 500 index) without making any deviations or analytical bets. In particular, the Wall Street Journal points out that 95.4% of U.S. mid-cap funds, 93.2% of U.S. small-cap funds and 92.2% of U.S. large-cap funds trailed their respective benchmarks. That means that long-term investors not only paid unwarranted fees, but also were subjected to inferior returns over one and a half decades.

Even the argument that it is primarily short-term investors who are the ones who benefit from active management seems to be undermined by this report. According to the SPIVA report, for the year 2016, large-cap funds failed to keep up with the S&P 500 66% of the time, while mid- and small-cap funds were outperformed by their benchmarks 89.3% and 85.5% of the time, respectively.

This could help explain why hundreds of billions of dollars have shifted from active to passive index funds over the past decade as investors have paid more attention to fees and relative returns. Still, active funds market themselves as better strategies than indexing.

There is one plausible claim put forth by critics of passive funds, that as more and more money pours into them, they will crowd out the strategy and provide active management with an edge. And while longtime investors know a market disruption or new market trends could suddenly give active managers an advantage, the latest 15-year study favoring passive managers indicates that shift may not happen anytime soon. (See also: Passive vs. Active Management: Which is Best?)