Why Passive Index Funds Beat Actively Managed Funds

I often find people discussing passive index funds versus actively managed funds online. People have all sorts of good and bad arguments for why returns should be higher on both sides. However, if we boil it down to simple mathematics, I don’t believe there is a lot to discuss.

Before we start, you should know that I am a big fan of passive index funds, and I believe it is the only way to go for long-term investments in stocks.

Why actively managed funds are more expensive

Actively managed funds are more expensive than index funds.

This is because the actively managed funds usually employ really smart people to find out what to invest in. These people are expensive, and they need expensive research and computing equipment to make the right selections and try to beat the market average.

Actively managed funds also spend a lot on marketing to try to convince people that they are smart. If you are investing in actively managed funds, you pay for this marketing.

The actively managed funds of course also have other administration and overhead costs that need to be financed.

Actively managed funds typically trade more often than passive index funds. This creates significant transaction costs through brokerage commissions, bid-offer spreads etc., which comes on top of the other fees.

A typical actively managed fund takes 2% of your investment in fees every year. They do this at the hope of being able to beat the market average by more than 2%, so you will get a better return than if you had invested in passive index funds. The very good actively managed funds get down to 0.5%, but they bad ones can go even higher to +3%.

The bad news is that this is that beating the market for all of the actively managed funds is not mathematically possible.

Compared to index funds, a good index fund from Vanguard can go down to 0.04%.

Let’s look at a simple mathematical example of why the index funds will always beat the actively managed funds.

Why passive index funds beat actively managed funds

Let’s imagine a scenario where we only have nine funds in the world. We have eight actively managed funds and one index fund (which is of course tracking the market average).

They are all worth 1 billion USD each at the beginning of a year.

Each of these funds yield a different return before fees after the first year.

Four of the eight actively managed funds perform below the market average of 10% in return. They have 6%, 7%, 8% and 9% in return respectively.

The other four actively managed funds perform above the market average with 11%, 12%, 13% and 14% in return respectively.

The index fund tracks at market average of 10% in return.

This scenario is illustrated in the following figure:

Now, let’s imagine that we compare each fund to the market average.

The figure below shows how many millions each fund has made compared to the market average before fees:

I guess the picture looks as expected, but once we introduce the fees that each of the funds charge, it becomes a different picture.

Remember that a typical actively managed fund takes 2% in fees out of your investment every year. A good, passive index fund in the US takes below 0.1%.

For this exercise, we apply a 2% fee to the actively managed funds and a 0.04% to the index funds which is what Vanguard charge for the their total US stock market index fund.

If we now look at the return last year after fees compared to the index fund, the picture is different:

Now only two out of eight funds outperform the index fund, and the index fund delivers a better return than the actively managed funds on average.

If you should choose actively managed funds over passive index funds, you will have to believe that you consistently over a lifetime will be able to choose the two actively managed funds that outperform the index every year. I have read enough studies about this to know that you most likely not will be able to do that. It is very few actively managed funds that consistently outperform the market average over time.

I believe that the risk of you choosing one of the five actively managed funds that underperform compared to the index is high.

I know this is extremely simple math, but people tend to forget how actively managed funds and index funds are tied to market averages and fees.

Other reasons that passive index funds are better

Not convinced yet? I also see a few other good arguments for choosing passive index funds over actively managed funds:

  • You remove the human factor or “manager risk” – the risk that people make mistakes or take too big chances – by choosing a passive index funds over an actively managed fund.
  • You don’t have to spend as much time finding out what their investment strategies are – you should choose a market that you want indexed and go.
  • Oh, did I mention they are cheaper?! If you invest $100,000 over 40 years and generate a 10% return, you will have paid $540,751 in fees to the actively managed fund, and $23,981 to the passive index fund. The $100,000 would be worth $1.87 million in the actively managed fund, but $4.04 million in the passive index fund simply because you invest the fees instead of giving them to expensive actively managed funds.

I know that I will continue investing in passive index funds, but I would love to hear from someone who is a supporter of actively managed funds to hear your thoughts on the subject.

Your turn: Do you agree that passive index funds are always the way to go?