A New Perspective on the Active–Passive Investing Debate

Active managers always outperform passive managers on a benchmark comparison. So why does nobody seem to care?


Here’s a fact that doesn’t get enough attention: By some counts, up to 86 percent of active funds underperform their benchmark, but by definition 100 percent of truly passive funds underperform theirs. Why is this? Because — unless they are taking some type of an active bet or have zero management and administration costs — they have to fall short of their benchmark.

As the debate over active versus passive investing continues, investors and regulators alike are overlooking a key point: Passive investing wouldn’t make anybody any money without active investing. Passive investors are essentially free riders, piggybacking off active managers at a fraction of the expense it takes to research investment positions. No one in the investment press focuses on this moral hazard or on whether or not this is fair to active investors, who effectively subsidize their passive brethren. The media question the value of active management, but they never bother to acknowledge that without it passive investment wouldn’t exist, let alone thrive. Passive investors only make money if markets move, and active managers are responsible for those movements.

Active investors undertake high-cost, high-value activities (price discovery) that passive investors benefit from — at a much lower fee. And they are taking full advantage: According to Morningstar, assets under management in passive mutual funds have skyrocketed 320 percent globally to $6 trillion since 2007. The growth of actively managed funds meanwhile has slowed significantly, with a like-for-like growth rate of 54 percent and total assets of $24 trillion.

The playing field has tilted in passive investing’s direction, and if passive investors want to continue to thrive, there must be a balance. Do regulators have a role to play here? They ought to be more cognizant of the uneven playing field when they examine how to regulate the markets moving forward. We’ve seen regulators in Europe going after investment fees for active managers, but why aren’t they scrutinizing fees for passive funds that, it could be argued, compete unfairly?

Active managers do need to take a hard look in the mirror and reevaluate where and how they add value, perhaps starting first with performance. One of the main reasons passive came into existence and has grown is because active funds reduced their raison d’être down to a quarter-over-quarter benchmark comparison. It is a mathematical certainty that, after fees, more assets will underperform the benchmark than outperform. Is this really the best that active managers can do to justify their existence? Whatever happened to the search for growth and value and to the proper purpose of the capital markets — to move capital to where the best risk-adjusted returns can be found? This is how the profession of investment management truly benefits society at large. Passive managers play no role in this noble work.

The best active managers are those with a goals-oriented approach that is focused on long-term objectives. Finally, in this persistently low-interest-rate environment, active managers will have to discover a fee model that is more commensurate with the value they provide. Too big a percentage of the investors’ returns is consumed by management fees.


We are seeing a race to the bottom, of sorts, when it comes to fees. Look at Fidelity Investments. Long known for being an active manager, the company recently announced it is cutting fees for 27 index mutual funds and exchange-traded funds to attract more assets into passive strategies. You can’t criticize them for the move: Investors have spoken, and increasingly they favor passive funds over higher-cost active funds that aren’t providing the value they hoped for. A spokesperson for the company said Fidelity still “believes in the power of active management.” It’s difficult to have power without value.

Until the industry addresses this value question, I think active management is doomed to continue to shrink. I’m in good company: Larry Fink, CEO of BlackRock, said last month he expects consolidation in the asset management business because too many managers can’t generate returns higher than their benchmarks and that the shift to indexing will be “massive.”

Active managers need to reinvent themselves. They need to focus on investment returns and not on growth of assets under management. They need to experiment with portfolios that are not constrained, have longer lockup periods and charge less. And above all else, the word “benchmark” needs to be removed from the active manager lexicon.

Paul Smith is president and CEO of the CFA Institute, which has more than 140,000 members worldwide.