Active vs. Passive

Active Versus Passive—Why and How to Use Active Managers

If you believed everything you read, you would probably conclude that indexing is a better investment choice than using active managers. It has been widely written that attempting to choose active managers tips your odds towards underperforming unmanaged indexes.

Hence logical investors who are prepared to recognize their limitations are best advised to take the edge that can be gained simply by indexing. While it is certainly appealing to see an important question resolved with finality, we do not accept that this is the case with the question of active versus passive. We admit there are good arguments in favor of indexing (we employ indexing ourselves if we cannot find a manager we are confident can beat an index) and agree that many investors overestimate their ability and would be better off with indexes. But just because most investors can’t successfully select active managers does not prove that it can’t be done. It just proves that it is difficult. Having read so much on a subject that we consider to be grounded in poor thinking, we are compelled to weigh in with some additional perspective and research.

First, let’s point out some of the obvious benefits of indexing. Indexing removes the uncertainty of decision errors (at least within an asset class) that could lead to poor performance. Indexing is also very low cost. Any incremental advantage in the world of investing is difficult to come by and usually highly uncertain—low expenses offer an incremental advantage that is both meaningful and certain. An active manager has to add enough value to overcome higher expenses. Given that the average manager in effect is the market, one should expect the average manager to underperform over time by an amount roughly equal to the expense differential.

Another advantage is that indexing offers style consistency, allowing investors to control their overall allocation more precisely (though there is no guarantee that investors will be able to do this effectively). Indexing is generally regarded as more tax efficient, but this is not always the case. It tends to be true for larger-cap indexes that are fairly stable, since there is less trading. But among smaller-cap indexes, where successful stocks grow in market cap and leave the index, the strategy can be tax-inefficient. For example: Vanguard’s small cap index fund has not been very tax efficient—though there is a new generation of small-cap index funds targeting greater tax efficiency. Indexing also requires less research and maintenance, at least from the investment selection side.

Based only in part on these advantages, indexing is attracting huge asset flows, while active managers have been maligned. Are active managers really that bad and are index funds attracting money for the right reasons? Let’s look at some of the wrong reasons that index funds are attracting so much money.

The S&P 500 has been on an unprecedented run for most of this decade, especially over the past four years. The gigantic-cap stocks that dominate the S&P 500 (it is weighted by size, so that larger companies account for more of the index) have rocketed forward, making it very difficult for the average actively managed mutual fund to beat the index.

This has attracted more and more investors to S&P 500 Index funds as they chase its hot performance. This reason for pursuing indexing is not a good one. It is primarily driven by large-cap out-performance. Large-cap outperformance has nothing to do with indexing and won’t continue forever.

The flip side of this phenomenon is disappointment in the performance of active managers. We think this disappointment is partially (but not entirely) misplaced. The assumption is that since the S&P 500 has outperformed the average active manager in recent years, we should conclude that active managers have not done well. It is not quite this simple. To understand the performance of the average manager we must understand what makes up the average. The universe of actively managed equity mutual funds includes large-cap funds, mid-cap funds and small-cap funds. When averaged, this group has much less of a large-cap tilt than the S&P 500.

In the environment over the last five years where bigger has delivered far higher returns, actively managed funds with their smaller-cap bias, have been at a huge disadvantage. Last year the S&P 500 returned 29.9 percentage points more than the S&P 600 small-cap index. In this type of environment the average active manager had no chance. The point is that comparing the average manager to the S&P 500 is “apples to oranges” and is not a basis for supporting indexing. Applying the same logic, the poor performance of a small-cap index fund last year relative to the S&P 500 would become an argument against indexing. Obviously it is not. The performance of the S&P 500 index relative to the average equity mutual fund tells us whether small-caps outperformed large-caps in a given year. It is not, however, a good benchmark for active manager performance. In fact, over the past 25 years, there has been only one year when small-caps beat the S&P 500 and actively managed funds didn’t. Table 1 shows the performance of the average equity mutual fund and the S&P 500 since 1975 (we don’t have fund data prior to 1975). Active managers have out-returned the S&P 500 numerous times and lost numerous times. Interestingly, over the full time period the returns of actively managed equity mutual funds are almost in a dead heat with the S&P 500, despite the significant small-cap driven underperformance in recent years. However, because large-caps have dominated now for most of the past 15 years, investors who compare fund performance to the S&P 500 are led to an exaggerated conclusion.


Ironically, the misperceptions resulting from the S&P 500 dominance have helped to spur growth of additional indexing options in the very classes where active managers have suffered from being inappropriately compared to the S&P 500. (Will these indexing options suffer the same fate if the S&P 500 continues to outperform?)

Better Benchmarks

The S&P 500 may provide a quick gauge of performance, and it may help compare funds from widely differing groups by providing a common yardstick, but is not a good benchmark for measuring management success for many funds. So how should a benchmark be selected? There are two basic problems that need to be addressed in choosing an appropriate benchmark to measure performance. First, the benchmark should be fair in that it represents the investable universe of the manager being measured. It makes no sense to compare a small-cap value manager to a large-cap growth index, since the manager is not eligible to invest in large growth stocks. Second, the benchmark should reflect the real world costs of running a portfolio. For this reason, we prefer index funds as benchmarks over the actual index (it also simplifies reinvesting income).

Given the smaller-cap bias in the fund universe, it is logical to assume that if appropriate benchmarks are used, active managers will look better than they do against the S&P 500 in some periods (including recent years), and not as good in others (such as the 10 years ended in 1983, when small-cap dominance helped the average fund leave the S&P 500 in the dust). Given the powerful dominance of the S&P 500 over the past decade, and the misleading statistics about active versus passive that result, we wanted to learn what the active/passive picture would look like if funds were compared to more suitable benchmarks during that span. Individually choosing benchmarks on 10,000-plus funds was not practical, but we were able to get a big step closer by using those indexes calculated by Morningstar to be the “best-fit” index for each fund. We looked only at distinct portfolios (as opposed to multiple share classes) in two broad groups: domestic equity funds and international equity funds. We then further subdivided each based on the indexes against which the funds compete. We assumed 40 basis points in expenses on the indexes, though for some funds there is no investable index available (the actual average expense ratio for all index funds is 0.97%, but the expense assumption made little difference in our results). We should note that only funds with a 10-year record were used, which could bias in favor of active managers since poor performers are less likely to have survived for the full period. Also, the best-fit benchmark is based on recent data — some style shift might have taken place over the years for some funds, though we think it is unlikely to materially impact the results. And we should note that these benchmarks are not necessarily the ones the funds have “chosen” to compete against. The best-fit indices are simply the ones that best describe a fund’s operating universe based on similarity in their performance behavior (some might argue that this is an advantage in conducting this kind of evaluation). Table 2 shows the results.


Overall, there are no major surprises: active funds failed to equal their benchmarks, though the margin is somewhat less than the S&P comparisons would lead one to think. Instead of 80% of funds failing to keep pace (as we have seen widely quoted), the “real” number is a little more than two-thirds (about 68%). But there are some interesting data that suggest when the odds may tip in your favor in selecting an active manager. Certain market areas and environments seem to convey advantages that active managers are able to exploit.

For example: International managers, who operated in a far lower-return environment than domestic managers, handily beat their best-fit benchmarks over the past ten years.

Managers have told us that they believe it is easier to beat a benchmark in a lower-return environment than it is in a higher-return environment. This suggests that if we are entering a lower-return environment going forward (as we think is likely) active managers could perform better than they have in the recent past.

Managers in specialized areas seemed to benefit from their focused expertise: 12 of 13 utilities managers beat their benchmark, as did 4 of 6 REIT managers. Technology, which is far more broad-based, saw half its managers beat their benchmark. Managers pegged against the Russell 2000 and the Russell 2000 Growth handily beat their bogeys, while those competing against the Russell 2000 Value did not. Some other observations: value managers generally seem to have fared worse against their benchmarks than growth managers. Managers competing against midcap benchmarks also fared poorly, as did those competing against large-caps. A little less than half of those managers competing against the full equity universe (Wilshire5000) outperformed—a respectable showing.

Is it Getting Harder to Find Successful Active Managers?

If you created thousands of portfolios and actively managed them using darts, a normal distribution assures that some will outperform a benchmark while others will not. Thus the past performance of successful active managers in the real world is by itself useless—it is entirely consistent with chance. The only value will come from the ability to successfully predict which managers will be successful going forward.

We view it as our job to identify the managers that we believe will beat index benchmarks. We look for a number of things in assessing whether we are confident that a manager or team will be able to continue its success into the future. First, we like to see a disciplined, research-oriented and clearly articulated investment process—this limits decision errors and helps ensure that things don’t fall through the cracks. We like low expenses. Low expenses not only decrease the obstacle that an active manager must overcome in order to best an index, but they also reflect a commitment to performance and to the shareholder.

We also look for strong team dynamics, where applicable. We favor groups that not only have very bright, motivated people, but that seem to like each other and work together well. This builds our confidence that the team will stay together in the future. We like to see a passion for investing, rather than a passion for asset growth and “empire building.”

Asset growth has made the job of selecting active managers harder than it used to be. Funds and firms that grow too large too quickly bring on a host of problems that time and again have led to serious performance degradation. In the case of a small boutique firm, sometimes the founder-manager is forced to deal with administrative and marketing issues required for growth. This cuts back on the time available for what got them there in the first place: stock picking. With any size firm, success begets asset growth, which leads to the dilution of investment ideas and talent. Success also begets job offers. Today not only managers jump ship, but entire teams are lured away. Still there are some funds that manage growth with shareholders in mind. These are the funds we are looking for.

Finally, it is important that we can identify an edge—something unique to the approach or process that improves their odds for success versus their competitors. An edge might be a proprietary screening model, a unique information network, or an investment process that focuses on unique factors, a longer time horizon or getting information quicker. If we cannot find a manager in whom we have confidence as to their ability to beat the benchmark, then we will index instead. Remember: we have nothing against indexing, and we want to do what will be best for our clients. To gain this confidence requires doing research at a depth that we believe no one else is willing or able to go to. That is our edge.


Indexing is a reasonable strategy that offers real advantages for investors who are not confident they can identify active managers likely to succeed (we think in most cases we can).

Conventional wisdom that passive investing largely outperforms active investing is correct, though not nearly as extreme as S&P-based comparisons have led the investing public to believe. At any rate, this by itself should surprise no one—active managers, as a group, “should” underperform the entire market by roughly the amount of their extra expenses.

The real question is whether it is possible to predict which managers will outperform. If only 1% of active managers can beat the market after expenses, but it is always the same 1%, then active management “wins” as a strategy. If 50% of active managers beat the market after expenses and there is no way to predict which those will be, then active management “loses” (it is effort expended for no result).

Some areas of the market appear to lend themselves to active managers over indexes. These areas include small-caps, international, and growth. Areas where active managers have historically had a tougher time beating indexes include value investing in across all capitalization ranges.

We believe in using active managers only when our research leads us to a high degree of confidence that we understand why and how a manager has outperformed, and that the right pieces are in place for the outperformance to be sustained in the future. In areas where we don’t have high confidence, we use index alternatives.