Passive Funds Versus Active Funds: The Conclusive Results

Despite terrifying actively managed fund results like this,

“84% of large-cap funds generated lower returns than the S&P 500 in the latest five-year period and 82% fell shy in the past 10 years.”

actively managed funds have somehow lived on, like blood-thirsty zombies. Not only that, but they are still thriving! In fact, as recently as April of this year, 67% of all invested U.S. assets were in actively managed funds.

I’ve discussed why active vs. passive investment levels are so backwards previously. In summary, it amounts to 4 things:

  1. A lack of good passive investment options in employer sponsored plans.
  2. Marketing and advertising dollars are poured into promoting actively managed funds, but not passive funds.
  3. Those not under fiduciary standard had not needed to disclose conflicts of interest. This was at the center of the White House’s call for an expansion of the fiduciary standard and the financial industry’s strong opposition to it.
  4. Human desire to outperform the averages.

While we don’t have much control over #1 – #3, we have plenty of control over #4. With actively managed funds having expense ratios that are so much higher than passively managed funds (in order to pay exorbitant salaries, bonuses, and advertising expenditures), the only reason to even consider opting for actively managed funds is hope for outperforming the index averages that passive funds try to match.

Fortunately, a recent Morningstar report, The Predictive Power of Fees, should throw some water over that hope.

“The lowest-cost U.S. equity funds succeeded three times as often as the highest-cost funds. The least-expensive quintile had a total return success rate of 62 percent, compared with 48 percent for the second-cheapest quintile, 39 percent for the middle quintile, 30 percent for the second-priciest quintile, and 20 percent for the most-expensive quintile…The pattern was pretty similar in other asset classes.”

Success ratio = the fund survived and outperformed the averages, by the way.

To recap, costs increased with each quintile and were less and less likely to “succeed”. Funds in the cheapest quintile were more than 3 times more likely to succeed in outperforming the average than those in the most expensive quintile! That’s not just conclusive, but it’s a freakin’ blowout! And it’s across all asset classes:

passive funds beat active funds

And when you look at average performance for each quintile, the annual total return percentages really stick out:

active vs passive fees

The author of the study definitively concludes,

“The expense ratio is the most proven predictor of future fund returns.”

Granted, the study isn’t a straight up passive vs. active fund comparison as linked to in the first article. However, most passive funds are going to fall into the first quintile, with their low expense ratios, while actively managed funds will mostly fall into the other quintiles. The takeaway is this: high expense ratios eat in to fund performance, outweighing any other perceived performance benefits. And actively managed funds have higher expense ratios than passively managed funds, and subsequently lower performance.

Of course, don’t just take it from me, take it from the greatest investor of all time, Warren Buffett. Warren Buffett recommends investing in index funds, and he even decided to put his money where his mouth is in a bet with hedge fund managers back in 2007.

Buffett made a $1M bet that by investing in an unmanaged, broad-market low-fee index fund (Vanguard’s S&P 500 index fund, VFINX), he could beat the performance of a high-powered hedge fund with a team of managers (and a hefty expense ratio). Here are the results:

buffets hedge fund bet

The passively managed VFINX tripled the total investment return of the hedge fund. And that included the Great Recession dip (where the hedge fund actually did win that year).

Here’s what Buffett had to say about the bet,

“[Losing by 40 points] may sound like a terrible result for the hedge funds, but it’s not a terrible result for the hedge fund managers. If you have a couple percentage points sliced off every year, that is a lot of money… It’s a compensation scheme that is unbelievable to me and that’s one reason I made this bet.”

Thanks for keeping it real, Warren.

As an amateur investor, you don’t need to place $1M bets. You can start using passive index investing to beat the pros at any time.

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  1. Steve
    • tony from NY

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