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In Mutual Funds, is Active vs. Passive the Right Question?

Whether we’re talking about sports or investing, people have an urge to win. In investing, investors seek outperformance. Thus, most mutual fund shareholders aren’t satisfied with the performance of a humble passive benchmark such as the S&P 500 Index. Instead, they search for an actively managed fund that they believe will beat the benchmark. Gerstein Fisher examined the perennial active vs. passive question from a few vantage points and made some interesting discoveries.

The Choice

The first conclusion should be no surprise to most investors: over extended time periods (15 years, in the case of this study), most actively managed funds have a challenging time beating passively managed index funds after fees. Using Morningstar’s fund database, we examined the performance of more than 2,000 active US equity funds during the 15-year period from July 1, 1998 to June 28, 2013. Result: only 25.6% of the active funds currently in existence outperformed their benchmarks (nearly 75% trailed the benchmark or had an insufficient track record to compare). Many other studies over extended time periods have reached a similar conclusion, including Standard & Poor’s, which found that 69% of all domestic equity funds were either outperformed after expenses by their benchmarks over the prior five years or had been liquidated during the period from Jan. 1, 2008 to Dec. 31, 2012 (Source: S&P Indices Versus Active Funds Scorecard).

At Gerstein Fisher, we tend to think that markets do a pretty good job of pricing risk; thus, investors are better off buying the market than trying to beat it. Considering how much information is embedded in the price of securities, it’s not an easy task to identify mispriced securities and outperform the market based on information that only one of us has versus the average for all of us. In the market, a dollar of outperformance by one investor is matched by a dollar of underperformance by another. Add to that higher costs for actively managed funds, such as annual expense ratios and transaction costs, and it’s clear why active funds start with a large handicap.

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