Active and passive funds

In simple terms

There are two broad approaches to running a fund:

• Active funds employ managers who try to beat a benchmark index by choosing shares they think will do better, avoiding ones they think will do worse, or changing how much is invested at different times.
• Passive funds, mainly index funds and ETFs, aim simply to match an index, as the index funds lesson explains.

Active funds cost more, because research and trading cost money. The question is whether they deliver enough extra return to cover those costs.

The arithmetic of active investing

Consider all investors in a market. Together, they own the whole market, so before costs their average return must be the market's return. Passive investors earn the market return minus small costs. So active investors, as a group, must also earn roughly the market return before costs, and less after their higher costs.

This does not mean no active manager can win. It means the average active rupee must trail the market after costs, and for every winner relative to the market, someone else trails.

What the evidence shows

Studies comparing active funds with their benchmarks over many years and markets, including regular reports published by index providers, have generally found that:

• most active equity funds underperform their benchmarks over long periods after costs;
• the share that underperforms usually rises the longer the period examined;
• results vary by category, with some categories and periods more favourable to active managers than others;
• results vary by country and period, so recent findings for one market may not hold in another.

Look at the latest such reports for the categories you are considering, and compare funds with the right benchmark, using the total-return version of the index.

Survivorship in fund data

Funds that perform badly are often closed or merged into other funds. They then disappear from performance tables, leaving only survivors, which flatters the average. This is the survivorship bias problem.

Past winners rarely keep winning

Fund advertisements highlight funds with strong recent returns. Research on persistence has generally found that top-performing funds over one period rarely stay at the top over the next. Some of what looked like skill was luck, a favourable style or a sector that happened to do well. Choosing funds by recent returns tends to mean buying after their best run.

Choosing between them

Points to weigh:

1. Costs: a higher expense ratio must be overcome every year.
2. Benchmark: compare an active fund with the index it is supposed to beat, over long and full market cycles.
3. Consistency and process: a clear, repeatable strategy explained in plain terms, rather than a record built on a few lucky bets.
4. Your own time and interest: choosing and monitoring active funds takes effort; an index fund needs little.
5. Role in the portfolio: many investors use low-cost index funds as a core and add active funds only where they have a specific reason.

Why it matters

Fund selection is one of the most common investment decisions, and one of the most heavily marketed. Understanding the arithmetic, the evidence, survivorship and the weakness of past performance helps investors avoid paying high costs for returns that, on average, do not arrive.

Limitations

This lesson summarises the general findings of research in broad terms. Results differ by market, category and period, and a minority of active funds do outperform. Future relative performance of active and passive funds may differ from the past.

Common mistakes

• Choosing funds by last year's returns.
• Comparing with the wrong or price-only benchmark.
• Ignoring merged and closed funds when judging a fund house.
• Assuming higher costs mean better management.

Try it yourself

1. Choose an active large-company fund and an index fund tracking a large-company index.
2. Compare their returns over 1, 3, 5 and 10 years with the total-return index, and their expense ratios.
3. Find the most recent report comparing active funds with their benchmarks for that category.
4. Write down which you would choose for a 15-year goal, and why.