The debate between active and passive investment management [1] is one of the most well-trodden discussions in the field of finance. Active management advocates argue that skilled fund managers can outperform market indices through expert analysis and trading strategies. However, a growing body of empirical research challenges this premise. Studies consistently reveal that passive strategies, such as index funds, offer superior long-term returns when considering the effects of fees, transaction costs, and market inefficiencies.

This article delves into the mechanisms that limit the effectiveness of active management while exploring contexts where it can succeed. By examining economic and statistical evidence, we aim to provide a balanced perspective and recommend actionable strategies for investors navigating these options.

Active Management: Theory and Reality

Active management is predicated on the belief that fund managers can consistently identify mis-priced securities, leverage market inefficiencies , and time market movements to beat the broader market. In theory, this outperformance would justify the higher fees and transaction costs that are characteristic of actively managed funds. However, this assumption overlooks several key factors:

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— High Management Fees: Active funds generally charge higher management fees (0.5% to 2% annually) compared to passive funds (0.1% - 0.5%), significantly eroding returns. Additionally,

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— Transaction Costs: Active managers trade frequently if they perceive mispricings or to capitalize on short-term trends. Each trade incurs costs like commissions and the bid-ask spreads. The costs due to higher turnover rates of active funds (0.5% - 1% per year) further eat into potential returns.  

— Market Efficiency: According to the efficient market hypothesis (EMH), markets are informationally efficient, meaning that prices already reflect all available information. In such an environment, outperforming the market consistently becomes exceedingly difficult for active managers[2]. Even assuming that active managers possess superior insight, their ability to capture mispricing is limited by transaction costs and competition from other market participants.

The Negative-Sum Game Argument

In the world of active management, the term "negative sum game" refers to the concept that due to the high fees and transaction costs, even if some active managers outperform the market, the overall collective performance of active managers will be lower than the market’s return. The net aggregate returns of active managers are lower than those generated by passive strategies. The aggregate gross return of active managers must equal the market return. Taking fees and costs leads to an overall underperformance.

This argument is not new; over 30 years ago, Sharpe [3] , in “The Arithmetic of Active Management”, stated that active management is a zero-sum game for gross returns and a negative-sum game for net returns. In aggregate, all investors are invested in the whole market. Passive investors will earn the market return. Active managers invest in subsets of the market, with the aim of picking the winners. But in aggregate, active managers will also hold the market: If an active manager buys more of a stock or asset class, there must be another who is owns less. Since active managers as a group must hold the market, in aggregate, they will also earn gross market returns. Each active manager’s gain will be another’s loss. If you take active managers’ fees into consideration, active managers’ net aggregate returns will be lower than passive managers, hence the negative-sum game.

Empirical Evidence

Empirical studies like the SPIVA reports and Morningstar research consistently find that most active managers underperform their benchmarks over long periods. For instance, the SPIVA reports, published by S&P Dow Jones Indices, provide semiannual analyses comparing the performance of actively managed funds to their respective benchmark indices across various regions and asset classes. These reports offer valuable insights into the effectiveness of active management strategies. They regularly find that the United States, approximately 85% of active managers fail to outperform their benchmark indices over a 10-year period. The performance numbers are similar for global funds.

Morningstar finds similar results, 85% of active funds failed to outperform the S&P500 over a 10-year period. It was found that active funds underperformed passive funds by an average of 0.5% per year for the same period. After factoring in fees and transaction costs, the underperformance increased by 1% to 2% annually.

Despite these findings, investors' focus on outsized returns has spawned a whole army of managers and researchers bent on beating the market over short horizons, with most failing. It is ironic that in that effort to be the best, the very fact that the industry hired the best experts, mathematicians, and physicists, has made it even more difficult beat the market. The more brain power and expertise are competing, the harder it is to beat our peers and the reference markets once fees are taken into consideration: The marginal benefit of additional expertise decreased while its cost increased.

However, certain contexts provide opportunities for skilled managers to excel. Inefficient markets characterized by lower liquidity, higher volatility, or limited transparency often present fertile grounds for active strategies. Recognizing and capitalizing on these opportunities requires a deep understanding of market dynamics and a disciplined approach.

The Challenge of Identifying Exceptional Managers

While the majority of active managers fail to outperform, exceptions exist. In my career, I have met hundreds, if not thousands, of fund managers. Many claim excellence, but only a select few consistently demonstrate the skill, discipline, and philosophy required to outperform benchmarks. Unfortunately, most investors lack access to these exceptional managers.

Financial advisors and private bankers often highlight their ability to connect clients with top-tier managers and emphasize the sophistication of their evaluation processes. In practice, identifying and gaining access to truly exceptional managers is no small feat, and remains one of the most significant challenges for investors. Their path to success lies in partnering with advisors and institutions that prioritize transparency, rigorous due diligence, and a commitment to aligning client interests.

In highly liquid and developed markets, the likelihood of identifying top-performing active managers who consistently outperform net of fees is low for most investors. In general, the key to success lies not in trying to outperform in efficient markets but in partnering with skilled managers who excel in contexts where inefficiencies or high barriers to entry create opportunities. Active strategies can thrive in these environments. For example, niche sectors or emerging markets often provide fertile ground for skilled managers to add value. It then becomes important to align portfolio management with the specific characteristics of each market or asset class.

A Strategic Approach: Starting with a Systematic Process

Given the inherent challenges of active management, an effective starting point for most investors is a predominantly passive investment strategy. However, what we propose goes beyond traditional passive investing. We have developed a scientific and systematic framework for portfolio construction and management to deliver better risk-adjusted returns than traditional passive strategies and can achieve the return objectives promised by active managers—without the associated high fees.

This approach avoids reliance on forecasts, market timing, or subjective predictions. Instead, it focuses on identifying and leveraging the structural drivers of portfolio performance—such as diversification, volatility reduction, systematic risk management, and cost efficiency. By applying this disciplined and repeatable process, investors can build portfolios that exploit market inefficiencies while minimizing unnecessary costs and risks.

Our strategy has been extensively tested and validated. For those seeking deeper insights, a detailed description of the rationale and mechanics behind this approach is provided in a separate article. This method ensures scalability and applicability across a wide spectrum of investors, from retail to high net worth families to institutional, regardless of their constraints or financial means.

While this disciplined framework serves as the foundation, opportunities for active management should not be ignored entirely. Our efforts in identifying active managers will focus primarily on areas where they are most likely to succeed—markets characterized by inefficiencies, illiquidity, or high barriers to entry, such as emerging, niche, or private markets. By targeting these contexts, where skilled managers have the greatest potential to add value, we aim to complement the reliability of our systematic investment process with selective, high-impact active strategies.

Ultimately, the key to a successful investment strategy lies in aligning portfolio management with the specific characteristics of the markets and asset classes involved. By leveraging the cost-efficiency and broad exposure of passive investments while selectively incorporating active opportunities where inefficiencies exist, investors can achieve a well-rounded and effective approach to portfolio management.

Conclusion

Active and passive investment strategies each have their strengths and limitations, but their effectiveness often hinges on context and execution. The aggregate evidence strongly supports passive management as a reliable and cost-efficient foundation for most investors, especially in highly efficient markets where the odds of outperforming after fees are slim.

Active management can play a complementary role when applied judiciously. By leveraging passive strategies as a default and selectively incorporating active opportunities in less efficient markets or niche sectors, investors can create a hybrid approach that balances consistency with the potential for superior returns. This requires rigorous research, careful evaluation of managers, and a deep understanding of market dynamics.

Ultimately, the key to successful portfolio management lies in adaptability. Investors must align their strategies with their specific goals, constraints, and market conditions, using the strengths of both active and passive approaches to build resilient and effective portfolios. By recognizing the nuances of both methods, investors can navigate the complexities of today’s financial landscape with confidence.

[1] Passive management refers to an investment strategy that aims to match the performance of a market index (like the S&P 500) rather than outperform it. It involves minimal buying and selling of securities, typically through index funds or exchange-traded funds (ETFs), and focuses on long-term growth with lower fees.

In contrast, active management involves a more hands-on approach, where portfolio managers actively make decisions about buying and selling investments with the goal of outperforming the market. This strategy requires more frequent trading and often incurs higher fees due to the active involvement of fund managers.

Passive management seeks to replicate the market’s performance, while active management aims to beat the market, though with higher costs and more risk.

[2] Arguably, active managers may have the potential to outperform in emerging markets because these are seen as less efficient due to factors such as lower liquidity, less transparency, higher volatility, political instability, and underdeveloped financial systems. But, like developed markets, for active managers as a whole, the zero or and negative-sum games arguments remain valid.

[3] Sharpe, W. F. (1991). “The Arithmetic of Active Management,”, Financial Analyst Journal 47, 7-9.