Why most active funds lose to the index

Why most active funds lose to the index

The case against active management is usually made with a chart of past performance, which is the weakest way to make it. The stronger case needs no chart at all, because it follows from accounting. Once costs are included, the average actively managed euro must underperform the average passively managed euro. Not usually. Must.

That is a statement about averages, and it leaves room for a talented manager to win. It also sets the bar that every active fund has to clear before it deserves your money, and the bar is higher than the fee difference suggests.

The arithmetic settles the argument first

Start with everything that is invested. Every share is owned by someone, so all investors together hold the whole market. Before costs, the average euro invested earns exactly the market return, because that is what the market return is.

Then subtract costs. Index funds charge little, active funds charge more, and both are paid out of the same pool of returns. The average actively managed euro therefore earns the market return minus active costs, and the average passively managed euro earns the market return minus passive costs. The gap between them is the cost gap, and no amount of skill changes an average.

This is the argument William Sharpe published in 1991, and it has survived every market since, including the ones where active managers did well. What it does not say is that every active fund loses. What it says is that active funds as a group cannot all win, and that the ones that do must win by more than they charge.