Why Passive Index Funds Beat Actively Managed Funds

Index funds vs 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?

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14 Comments

  1. You have great points. My main problem with choosing index funds is psychological: I have a hard time choosing an investment where I am GUARANTEED to have returns below the market (market return minus fee even though it may be small). I just really can’t wrap my head around that. I don’t want to be guaranteed to have returns below market average. May in addition to buying individual stocks like TalkAboutFinance suggest you could sell covered calls or covered puts. This reduces overall risk and risk adjusted return. But then again it also requires more time and effort – and are we not striving for some sort of independence? How independent are you really if you have to monitor your portfolio.

    Great post, gave some food for thought. Keep it up

    1. I know exactly what you mean – very good points indeed! I also don’t want to have returns below the market average, but I see it as the cost of simplicity. I pay the fund managers a small percentage (although I think it should be even smaller) for the simplicity of not having to spend a lot of time on investing, nor do I have to choose anything myself and I am can still be very well diviersified.

      Can you put a few more words on the covered calls or covered puts? Where would you trade that and how?

      1. Just leaving a reply here so I get notified on the covered call or put strategy. Would like to hear more about it although I am sceptical about the costs of such a strategy.

        Also I want to add that given that you buy indexes you must be a firm believer in the efficient markets hypothesis. This thus implies that you do not care which stocks you own as long as your portfolio is diversified –> You can get your simplicity by simply buying random stocks from a range of geographical/industrial indexes 😉

        1. Very true, TAF! 🙂 How many random stocks would you buy if you need full diversification across industries and world reigons? And what do you do with rebalancing as you go? To me it sounds like too much of a hassle and transaction costs might turn out more expensive than investing in index funds.

          1. That ended up being a long comment. Answers summarized: (1) +30 stocks, (2) Costs should be similar (3) Time spend depends on experience – down to 2min/month but could be much more.

            Well that depends on your desired level of diversification. Of course a global index with thousands of stocks gives a better diversification, but in my opinion it comes with a too high price tag in Denmark – especially in the low interest environment we have today. Working towards a specific number you can use empirical research (ex. 1977 Edwin Elton and Martin Gruber – An easy read can be found on wikipedia https://en.wikipedia.org/wiki/Diversification_(finance)#Amount_of_diversification ) that says that a standard deviation on a portfolio of 30 random stocks is actually very close to a portfolio of 1000 random stocks. The correlation in the financial markets over time is stronger than you would expect so adding more stocks above 30 will only get you marginally closer to the covariance in the market. And I expect the financial market should be even more correlated now than in 1977 when they published the article. I will however highlight that if you go with around 30 stocks I think you should think about the exposures of the portfolio so it have stocks with different risk profiles, industry exposures and geographical end market exposures (not to be confused with the geography the stock is listed).

            Costs are not that big of an issue in the phase where you still add to your portfolio. I guess the costs of adding a new stock every month to the portfolio is similar to adding to your index fund portfolio every month, so no difference there if you don’t use free services like Nordnets monthly saving system.

            Balancing in the build-up phase can be done by adding stocks in weak areas instead if selling in the performing areas. As such transaction costs stay as they would have been anyway when adding to any portfolio.

            But of course this strategy is not for everyone. It requires your portfolio to be large enough to be spread out and it requires you to know just a little bit about your portfolio so that you have an idea of what areas you should add to next time you add to your portfolio. That might take 2 minutes a month for some people and much more for others. But as I mentioned before, if you buy index funds now you must be a firm believer in efficient markets so there is no reason to spend too much time going all analytical on the companies you owns or want to buy. A superficial overview of the exposures would be enough.

            Ps. Don’t forget the tax effect as explained in my reply to your comment on TAF. The result of it depends on your withdrawal behavior, but I believe it could be significant for people with long withdrawal periods eg. FIRE.

            1. Very interesting, TAF! Thanks a lot for the in-depth explanation, it makes good sense – and good point about the tax effect too.

              I agree that the costs could be similar and that you could do it relatively quickly each month. I might spend more time though because I would find it fun to look at different companies to buy.

              However, in terms of diversification, I am not sure that 30 stocks would give me global diversification. Right now, I have an index in the US, Europe, Denmark and Emerging Markets (Asia + South America). If I had to be diversified across all of these regions and sectors (that also differ between countries) at the same time, I believe I would need more than 30 stocks. Am I wrong here?

              1. No you are right. Indexes do of course provide a better diversification. It is up to you if you value the diversification or no annual expenses most.

                30 different stocks is an absolute minimum and I agree with you, but it’s diversification actually comes closer to an index than you think. You mention different indexes all over the world but I might challenge your thinking by asking what diversification a company like Unilever provides? It’s listed in the Netherlands/UK so that’s where an index would put it but it only generates 7% if it’s revenue from these two countries. Other than that I would highlight correlations in the stock market and general economy again.

                Fun fact: Unilever actually generates 43% of its sales in emerging markets so just owning this European stock would put you overweight in emerging markets 😀

                1. That is very true 😉 You could also reverse that argument. The very fact that all companies have different industry/geography exposure puts even bigger demand on your knowledge about the companies you invest in doing single stock investments (and thus more time needed).

                  How about we make some fun out of this? We could write a monthly/quarterly/yearly update on single stock investing vs. index fund investing, and we can compare numbers as we go (even though historical data of course doesn’t say anything about the future)? We can either alternate those posts or I can do them.

  2. Good article promoting an important message. Its crazy how a few fund managers can still charge +3%. May I ask which funds you hold?

    As to WWE’s comment on index funds vs individual stocks I have actually been thinking about this more and more recently as I see potential systemic risks in passive funds (selling in flash crashes or liquidity) and a lack of decent funds available in Denmark due to taxes.

    I think buying (many) individual stocks is a very good alternative to index funds if you have a large enough portfolio to keep costs insignificant. You don’t need 500+ stocks to be diversified and you don’t really need to keep your weights exactly like the indexs. Who says the index you picked has the right stocks and weights anyway? Following an index will most likely get you a significant size/momentum bias… By buying individual stocks you remain in control, can optimize your taxes and could save money if you are a long term holder as even index funds has running costs (Although some funds keep them VERY low).
    I have actually written about it a few weeks back – feel free to read it. But I stress that your emotions could ruin the strategy if you suddenly think xyz is too cheap or expensive 😉

    1. Yes, you are absolutely right. It is crazy that they can charge +3%! I hold the cheapest 3 x Sparinvest and 3 x Danske Invest funds spread across the world (except South America actually – I couldn’t find any cheap funds for that).

      I agree with you that buying individual stocks can be a way to go to mimic index funds, but I would say that it still comes at the risk of high transaction costs or an unbalanced portfolio – and of course, as you say, you are your own worst enemy. I know for a fact that I (despite my knowledge about behavioral finance) tend to want to invest in index funds that have given me a better return in the past month when I make my monthly investments. Super irrational 🙂

      Just read your article – I really enjoyed it!

      1. Saxo Bank just introduced a flat brokerage fee at 0.1%, and no minimum fee. I’m currently holding Danske Invest index funds, but is really tempted by this offer. Only catch I can see is the currency exchange fee (0.5%) – if a stock pays dividends, and you reinvest, perhaps you are better off just paying Nordnet the minimum brokerage fee in exchange for a better exchange fee (0.15%), although I haven’t crunched the numbers, so I cannot say for sure.

        1. That sounds like a really good deal from Saxo Bank (except of course the currency exchange fee depending on how exposed you are to that). Thanks for letting me know, I’ll try to crunch the numbers on this in the near future.

  3. Great article Carl! I’m also a fan of indeks funds, however it’s sad that we don’t have more competition in the danish market.

    I’m also wondering whether it would be better to pick individual danish stocks as we have a rather small indeks with only 25 companies. Why not pick the 5 best performing Danish stocks and then choose a global indeks fund to do the heavy lifting in the portfolio? I’d like to hear your thoughts on the matter.

    1. Thanks, WWE! I am glad to hear that you are also a fan. I highly agree that it is a big shame that we don’t have more competition in the Danish market. Hopefully that will change with the new tax regulation.

      I guess you could pick individual Danish stocks, but you would not get the same diversification as with an index (even though it is only 25 in DK) and the trading costs might not be worth it if you re-balance often and strive for a certain distribution of the stocks. Also, picking the five Danish stocks is the hardest part I think, but I guess it would be interesting to investigate further to avoid those high Danish index fund management fees.

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