Active vs Passive Investing

Passive investing means buying a fund that tracks a market index, such as the S&P 500, and holding it, accepting the market's return minus a small fee. Active investing means trying to beat the market by selecting securities, timing trades or tilting toward particular themes, usually at higher cost. The debate between the two is one of the most studied questions in finance. The evidence is clear on average, but the right choice depends on costs, skill, goals and what you enjoy.

The basic arithmetic#

Nobel laureate William Sharpe made a simple argument in 1991, often called "The Arithmetic of Active Management". Before costs, the average actively managed dollar must earn the market return, because active and passive investors together hold the market. After costs, the average active dollar must therefore underperform the average passive dollar, because active management costs more. Some active managers can and do beat the market, but as a group they cannot.

The evidence#

S&P Dow Jones Indices publishes regular SPIVA scorecards comparing active funds with their benchmarks. Recent US reports have consistently found that a large majority of active large cap equity funds underperformed the S&P 500 over 10 and 15 year periods, with the share often around 85% to 90% or more over 15 years. Results vary by category and period, and some areas, such as certain bond or small cap categories, show better results in some years. Persistence is also low: past winners often fail to stay in the top group.

The impact of fees#

Comparing the two#

The middle ground#

Where active management may add value#

• Less efficient markets: small caps, emerging markets, some bond sectors.
• Specialised strategies: market neutral, macro or trend following that provide diversification. See Hedge Funds.
• Risk management goals, such as reducing drawdowns, not just beating an index.

Traders and the passive benchmark#

Every active trader implicitly competes with the passive alternative. If years of trading produce returns below a simple index fund, after costs and time, the passive option would have been better. Tracking your results against an appropriate benchmark keeps this honest. See Investing vs Trading and Trading Journal.

Frequently asked questions#

Is passive investing better than active investing?#

On average, yes after costs, since most active funds underperform their benchmarks over long periods, though some managers do outperform.

Why do most active funds underperform?#

Before costs, active investors as a group earn the market return; higher fees and trading costs then leave the average active fund behind.

Can individual traders beat the market?#

Some can, but most do not after costs. Comparing your results with a passive benchmark shows whether active trading is worth it for you.

Next, learn the most common measure of potential loss in Value at Risk (VaR).