If you're wondering about active versus passive investing performance, you've come to the right place. Overall, it's better to be a passive index investor because it is very hard to outperform various stock market indices long term. The vast majority of active equity and fixed income fund managers underperform their respective indices.
One of the reasons why I left institutional equities in 2012 was because I felt it was a dying business. Trading commissions were getting squeezed due to algorithmic trading and other technological advancements.
Further, assets under management (AUM) for active money managers was also declining due to poor performance. It was obvious to me that passive investing was winning out over active investing.
The Rise Of Active Investing
Working harder and getting paid less was already demoralizing. Watching my clients I cared about work harder and underperform their respective indices made me feel like my job was pointless. When you feel like your job is pointless, it's time to do something new. I also grew tired of being an active investor.
Since the time I left my day job, the business has only gotten worse for actively managed funds. Yes, it is true that passive money managers gained a tremendous amount of assets during this time period.
As a career, however, there is no excitement speaking to an index fund manager or analyst because they don't do any analysis. All they do is follow the moves of their benchmark indices. For example, if the S&P 500 removes one name from its index, so does the index fund manager.
As of 2023, the market share of passively managed equity funds has risen to 45 percent according to Bank Of America. For passively managed bond funds, the market share is roughly 25 percent. The market share gains will likely continue.
Let's look at some active versus passive investing performance in equities and fixed income over the past 10 years. The results are shocking!
Active Versus Passive Investing Performance
Since 2002, S&P Dow Jones Indices has been publishing the SPIVA U.S. Scorecard. The scorecard measures the performance of actively managed equity funds investing in domestic and international equity, as well as fixed-income funds, against their respective benchmarks.
The University of Chicago’s Center for Research in Security Prices (CRSP) Survivor-Bias-Free US Mutual Fund Database serves as the underlying data source for the scorecard. As the CRSP database consists of publicly traded open-ended mutual funds, the fee structure primarily reflects retail products rather than institutional accounts.
Let's take a look at the 10-year historical performance of equities first and then fixed income second.
Equity Institutional Manager Performance
Institutional managers, in this case, are actively-run funds that manage institutional money versus retail money. An example of institutional money is the firefighter's pension of Texas. Another example is the sovereign wealth fund from Saudi Arabia. It gave Softbank $45 billion in capital to help create the $100 billion Vision Fund. What a mistake.
The below chart highlights that the majority of Institutional Managers in every equity investment category underperform their respective benchmarks, gross and net of fees.
The categories for percentage of funds that underperformed the most include: Large-Cap Core Funds (87.82% underperformed net of fees), Mid-Cap Core Funds (85%.11%), Multi-Cap Core Funds (84.29%), Large-Cap Growth Funds (81.69%). If you want to invest in actively managed equity funds, stay away from these categories.
The categories for percentage of funds that underperformed the least include: International Small-Cap Funds (59.52% underperformed), International Funds (66.28%), Multi-Cap Value Funds (66.94%), and Large-Cap Value Funds (65.28%). If you want to invest in actively managed funds, these are the categories where you have the best chance of outperforming.
Equity Mutual Fund Performance
The performance across all categories looks even more dismal than the performance from actively run institutional funds. Take a look at the chart below.
Only in the Equity Mutual Funds list do you see 90%+ of funds underperforming in categories such as Large-Cap Core Funds (93.27%), Mid-Cap Core Funds (90.23%), Small-Cap Core Funds (92.97%), and Multi-Cap Core Funds (91.79%).
Once again, the categories where actively run equity funds underperformed the least were International Funds (81% underperformed) and International Small-Cap Funds (64.15%). But saying that only 81% of the International Funds underperformed is like giving them trophies for getting Ds on their exams.
Overall, 77.97% of large-cap mutual fund managers and 73.21% of institutional accounts underperformed the S&P 500® on a gross-of-fees basis over the 10-year horizon.
There was one bright spot in 2018, however, and that's Mid-cap Growth funds. Mid-cap Growth funds offered the best relative performance among equity categories in 2018; an impressive 81.60% outperformed the S&P MidCap 400® Growth’s 10.34% decline last year.
See the 2018 performance chart below. Relatively speaking, 2018 was a great year for actively run equity funds compared to its 10-year history. But over the long term, sustained outperformance is virtually impossible.
Fixed Income Active Fund Performance
Now let's look at the performance of actively-run fixed income funds by Institutional Managers and Mutual Fund managers over the past 10 years. Overall, the percentage of funds underperforming by category is lower compared to actively run equity funds.
Institutional fixed income funds typically performed better than their benchmarks, gross of-fees, compared with their Mutual Fund counterparts. However, California municipal debt mutual funds posted the best relative performance figures over the 10-year horizon, gross-of fees.
But once you bake in the fees for California municipal debt mutual funds, the underperformance percentage goes from 26.32% to 36.84%. That is a huge 42% increase in the number of funds that underperformed. The percentage jump is even worse for NY municipal debt mutual funds.
Active Fund Management Fees Are A Big Killer For Investors
In other words, fees matter greatly. Fees matter much more in fixed income. The reason is because the average annual return for fixed income is lower than the average annual return for equity funds. Therefore, fees account for a greater drag on performance.
Hedge fund managers and venture capitalists get so rich is due to their exorbitant fee structure. Charting 2% of assets under management and 20% of profits or more is enormous!
Alas, I still like to invest in private funds for diversification purposes. It's my way to invest in promising startups.
Active Performance Gets Worse Over Time
Finally, the longer the time, the greater the percentage of actively run funds that underperform their respective indices. Below is a chart that shows the percentage of U.S. equity absolute returns and risk-adjusted returns funds that underperform the S&P 500 over 3, 5, 10, and 20-year period.
Why Do Investors Still Invest In Actively Managed Funds?
Based on the data, it is clear that investing in actively run equity or fixed income funds is a suboptimal financial decision over the long run. You can get lucky in the short-run, but in the long run, sustained outperformance is practically impossible.
One of the main reasons why Jack Bogle, founder of Vanguard was not a billionaire is because of low fees. If you want to get rich, then it's a good idea to work for an active institutional investor. Be a portfolio manager or analyst. You'll get paid big bucks to underperform!
Investing in a fund that performs better over the long-run and has lower fees is a no-brainer. Yet institutional and retail money continue to invest in actively run funds due to the following reasons: 1) hope, 2) marketing, and 3) pedigree.
Investors love to gamble. Despite the data saying that buying lottery tickets is a waste of money, the lottery system is still big business. The same goes for investors who invest in actively run funds. They are gambling the funds they invest in will finally outperform and make them richer.
Suckers For Great Marketing And Hope
Even though active versus passive investing performance makes passive investing in stocks and bonds better, we all like to dream.
Investors also get sucked in by great marketing and strong branding. Beautifully crafted words can make a difference in attracting capital. Over the short-run, slick websites and touching commercials also do wonders to attract capital. Great marketing often blinds you to the actual performance numbers until it's too late.
Finally, many investors feel better when an old guy who went to an Ivy League school is managing their money. When a computer or a guy who is just following index weighting changes, it's natural not to feel you're getting your money's worth. People tend to invest more when they feel more comfortable with the person at the helm.
Passive Over Active Investing All Day
The vast majority of your equity and fixed income investments should be in passively run funds. Your asset allocation between active and passive investments is up to you. I wouldn't invest more than 50% of my investable assets in active funds.
Here is my recommended split between active and passive investing for various types of people.
I personally shoot for ~80% passive and ~20% active investments. The reason is because I still have an affinity to some of the clients I used to cover. I also love buying individual stocks if I'm a consumer of their products. For over a decade, I own individual stocks such as Apple and Google based on my investment thesis that technology will innovate and outperform the S&P 500 over time.
If you still love the idea of actively run funds, know that there is a level of active involvement in deciding what goes into a particular benchmark and its weighting. For example, variables such as market capitalization, profitability, float and liquidity, and geographic revenue composition play a factor in determining the S&P 500 index composition.
Further, if you insist on investing in active funds, you should look for categories that have less than 50% of the funds underperforming their respective benchmarks.
Diversify Your Net Worth
The main things you can do to grow your net worth through investing is minimizing fees, being objective about the performance data, investing consistently, and making sure you have a risk-appropriate asset allocation. Once you do those things, all you've got to do is wait and you will eventually grow rich.
When it comes to active versus passive investing performance, there really is no comparison. Passive investing is the way to go for the vast majority of people. Beyond stocks, I strong encourage investors to also diversify into real estate. Real estate is a more stable asset class that generates passive income and provides utility.
For me, roughly 30% of my net worth is in equities. 40% of my net worth is in real estate. The rest of my net worth is in bonds, business equity, and private equity investments.
Stay On Top Of Your Investmeents
To get rich, you need to stay on top of you investments. Sign up for Empower, the web’s #1 free wealth management tool. It will allow you to x-ray your portfolio for excessive fees that you didn't know you were paying. You'll also see snap shot of your asset allocation and receive suggested allocation weightings based on your objectives.
After you link all your accounts, use their Retirement Planning calculator. It pulls your real data to give you as pure an estimation of your financial future as possible.
I’ve been using Empower since 2012 to manage my money. In this time, my net worth has skyrocketed partially thanks to better money management.
Diversify Into Real Estate
Look to diversify your real estate investments across the country where valuations are lowerand net rental yields are higher. Thanks to demographic trends post pandemic, growth rates may be higher too.
Check out Fundrise and their real estate funds. Fundrise enables investors to diversify their real estate exposure with lower volatility compared to stocks. Income is completely passive and there is much less concentration risk. For most people, investing in a diversified real estate fund is appropriate.
If you are bullish on the demographic shift towards lower-cost areas of the country, check out CrowdStreet. CrowdStreet focuses on individual commercial real estate opportunities in 18-hour cities. If you have extra capital, you can build your own select real estate fund.
Both platforms are free to sign up and explore. I've personally invested $954,000 in real estate crowdfunding to take advantage of deals in the heartland of America.
Invest In Private Growth Companies
Finally, consider diversifying into private growth companies through an open venture capital fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment.
Check out the Innovation Fund, which invests in the following five sectors:
- Artificial Intelligence & Machine Learning
- Modern Data Infrastructure
- Development Operations (DevOps)
- Financial Technology (FinTech)
- Real Estate & Property Technology (PropTech)
Roughly 35% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!
The investment minimum is also only $10. Most venture capital funds have a $250,000+ minimum. In addition, you can see what the Innovation Fund is holding before deciding to invest and how much. Traditional venture capital funds require capital commitment first and then hope the general partners will find great investments.
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