Active vs Passive

Active vs Passive Asset Management

The debate is over. Period. Passively managed index funds outperform actively managed funds. In 15 out of 18 categories of domestic equity funds, the majority of actively managed funds underperformed their benchmarks in the past 12 months. The performance was particularly underwhelming in the small-cap space, as 78% of all small-cap funds lagged the S&P SmallCap 600. The news is even worse for active managers over longer time periods. 84% of active small-cap managers lagged the index over the past 10 years and 94% lagged over the past 20 years.

Active vs Passive Asset Management

This is conclusive evidence that active management at all levels in the market cap structure are unable to simply beat their benchmark index. For a long time, active small-cap managers were given a pass on this debate because small-cap stocks had less Wall Street analysts coverage therefore an active manager could theoretically find small cap companies that were less known in the analysts world and exploit any information they found that the rest of Wall Street was unaware of. The theory was that as analysts reviewed companies as published their findings for investors to digest all information of any company was made public, therefore the ability of one investor to exploit good news about a company was less. Small cap companies simply had fewer analysts following them so an active could have discovered good news about a company that no one else knew and exploit that information by profiting from an investment decision relative to that news.

Do Active Managers Outperform their Benchmark?

This capability is becoming less so as there is more analyst coverage in small-caps and therefore less non-public information about any given small cap company. With access to software programs that can gather company financials and keep up with day-to-day activities at any company there is very little non-public information anymore and for any active manager to consistently outperform their benchmark over any time period has always been difficult and going forward will be almost impossible. Among those active managers that did outperform their benchmarks, 60% of them underperformed their benchmarks at some point by at least 20 percentage points.

Which Fund has a Higher Fee Structure?

Actively managed small-cap funds have another headwind to overcome as well. Actively managed small cap funds generally have a higher fee structure than mid and large cap funds. Their higher fee structure means managers have to overcome a higher hurdle than the passively managed index funds with their low cost structure. Based on Morningstar research, the average expense ratio for a small-cap fund with assets greater than $5 million is 1.61% compared to 0.06% fee for the iShares Core S&P Small-Cap ETF, symbol IJR that replicates the return of the S&P SmallCap 600 Index.

Active vs passive

Exhibit 1: Active U.S. Equity Funds: Average Annual Excess Return Before Versus After Hiring/Firing (1/1/96-12/31/18; Versus Category Benchmark Index)

Have more questions? Contact Us

Brad Lyons, CFP®
Investment Manager

By Published On: May 26, 2022

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