Can Active Funds Make Money for You Better Than Passive?

I was in my early 30s and had recently arrived in the US with a wife and two toddlers.

Things were tight, living on $31k. Very tight.

We were beyond happy to find that the local hospital cafeteria sold hot meals for under $3 because $0.20 supermarket ramen noodle packets were often dinner at our house.

Over five years, my salary increased by 23%, to $38k.

After inflation, however, the increase was just 8% – about 1.5% a year.

Before I got here, I had no idea about mutual funds, how they worked, or how to pick good ones. Once we scraped and saved $1400 to set aside for retirement, I needed to learn.

Luckily, if there’s one thing a physics PhD teaches you, it’s how to learn even complicated topics quickly. I went to the university’s library and looked for resources that would help me learn about investing.

Today, I’d use the Internet, but this was in the early ’90s…

I found the Morningstar Mutual Fund Directory, a pair of huge volumes, each with thousands of pages.

Each fund had its own page, dissecting it in detail – analysis, short- and long-term performance (absolute and vs. its index), risk vs. return (3-year, 5-year, and 10-year), fees, portfolio holdings, strategy, etc.

But even more interesting for a newbie like I was, they also had multi-page tutorials on what to look for in a great mutual fund, how to allocate your investment dollars between asset classes, and more.

I spent hours each day at the university library for three weeks before picking a fund I thought would do well for us – an active, aggressive growth small-cap fund.

For a while, it did well, growing our money 15% annually.

Then, things went south, and it came out that the fund managers had been favoring institutional investors over small-time investors like me, selling to them ahead of the line when the market went up, and buying their shares ahead of the line when the market soured.

The Lesson I Could Have, But Didn’t Learn and the One I Did Learn

You could be forgiven if you thought I’d take away the lesson that active managers can’t be trusted to play fair and still beat the market.

That’s not what I took away.

The lesson I learned was that good governance and placing shareholder interests ahead of the manager’s short-term interests are critical when picking a fund.

I also kept reading and learning from financial publications what’s important when picking funds.

The Accepted Wisdom About Active vs. Passive Mutual Funds

Many highly regarded investors, not least Warren Buffet and Vanguard Funds founder, the late John C. Bogle, said many times that most people will do better investing in low-cost index funds than trying to beat the market using active funds.

There have also been many academic studies proving that, over the long term, few actively managed funds beat their indexes.

Considering that the stock market’s long-term returns are over 10% (about 7% after adjusting for inflation), accepting index funds’ market-average returns less minuscule fees isn’t bad.

Of course, it isn’t great either.

It’s, well, average.

The Path I Picked

After learning the above-mentioned lesson, I developed my own set of mutual-fund-picking criteria that allowed my investments to beat the market by up to 1.5% a year with lower volatility.

When I read various articles on Medium essentially calling into question the intelligence of people who invest in active mutual funds, I published a piece comparing the 15-year performance of a basket of eight active (T. Rowe Price) funds against a basket of 12 passive (Vanguard) funds.

The active funds had crushed the passive index ones in each of three 5-year periods – 15-10 years earlier, 10-5 years earlier, and 5-0 years earlier.

What Recent Research Results Say About Both Sides of the Argument

The same company that published those heavy tomes I pored through in the university library decades ago now publishes their fund reports online.

They also periodically publish results from their research.

One example is their semi-annual US Active/Passive Barometer (most recently for Midyear 2023).

Here are some of their conclusions:

More than half of active funds beat the average passive fund over the 12 months to June 2023.

If you look at the past 10 years, up to 45% of active funds in each of the 20 asset-class categories they analyzed were closed or merged into others – if this was medicine, we’d say the doctors buried their mistakes…

Looking at the fraction of active funds that survived and beat their passive counterparts over 10 years, they found:

• 10-12% of US large-cap value, blend, and growth funds succeeded.
• For US mid-cap it was 9-14% for value and blend, but a surprising 46% for growth.
• US small-cap, value, blend, and growth achieved 33%, 28%, and 46% success, respectively.
• Active foreign and global funds had an average success rate of 29%.
• 53% of active US real estate funds outpaced their passive brethren.
• Active global real estate funds were nearly as likely to succeed – 52%.
• For fixed income, the success rate was over 30%.

The above offers supporting evidence for both sides.

While most active funds were able to beat the average passive fund over a single year, over a 10-year period that figure dropped by as much as 85% to fewer than one in 10 for US large-cap value, large-cap blend, large-cap growth, mid-cap value, and mid-cap blend.

For some categories, active funds had better numbers, especially real estate (US or global), mid-cap growth, and small-cap growth.

For the remaining categories, about one in three active funds succeeded over the last 10 years.

Across all categories, one in four active funds beat their passive counterparts.

Supporters of index funds would point to the failure of three out of four active funds as proof that you should be a passive investor.

Others, who like me prefer active funds, would tell you that you can learn how to pick long-term winners among active funds and trounce the passive funds’ returns.

An intriguing conclusion from Morningstar was that over the past 10 years, the average dollar invested in active funds outperformed the average active fund in nearly all categories. That supports my contention that investors can learn to pick winners and shun losers among active funds, thereby outperforming the average active fund as well as the average passive fund.

Thoughts from Financial Pros

Jacob T. Rothman, CPA, CFA, CFP®, Portfolio Manager, Rothman Investment Management says, “People often pick a fund by simply looking at recent performance. The problem with that is that the best recent performers usually rode the latest trend up to attain top-tier performance, and then revert to the mean when that trend falls out of favor. If you want to pick active funds, focus on the fund’s process and long-term risk-adjusted returns.

“Another possibility is to use quantitative funds, which are different than traditional passive funds in that they aren’t purely market-cap weighted, use objective-rule systems, and don’t have the high cost of portfolio management and research teams.

“Investors interested in active management should understand that paying an active-management-level fee for a fund that ‘hugs’ its benchmark is a waste of money. You get the average gross performance of a passive fund with the higher fees of an active fund.”

Caleb Vering, Associate Wealth Advisor, Farnam Financial points out, “When you choose a passive fund, you assume there’ll be broad and continuous economic growth in the future. When you choose an active one, you assume a portfolio manager can consistently choose winners over long periods of time. The latter are more expensive than the former, so they need to outperform by more than that cost difference. Whatever you do, consistency is paramount to long-term success as an investor. A prudent investor should choose funds they’d be willing to hold for 10 or more years. Chasing returns can be a major pitfall for your portfolio.”

The Impact of Small Outperformance Can Be Huge Over Time

Say you outperform the market by a mere 1.5% a year, achieving a real (i.e., inflation-adjusted) annual return of 8.5% rather than your index-investing friend’s 7%.

Over 20 years, you’d turn $500 a month into $315k (in inflation-adjusted dollars), 20% more than the market’s return that would get your friend to $263k. 

At the 30-year mark, you’d have $809k, 33% more than your friend’s $606k.

At 40 years, your $1.92 million would put you 50% ahead of your friend’s $1.28 million.

And after a 45-year investing “career,” your $2.93 million portfolio would be 60% bigger than your friend’s (still respectable) $1.83 million.

The Bottom Line

Like the debate about whether it’s better to buy a house or rent, the debate over investing in active vs. passive funds is unlikely to be definitively decided anytime soon.

Over the short-term, most active funds do outperform the average passive fund.

However, over the longer term, say 10 years or longer, you need to pick the right active fund or you’re far more likely to make less money than your friend who invests in low-cost index funds.

If you do learn how to pick winning funds, your money could grow far more than that friend’s. Potentially up to 60% more over 45 years. 

Assuming you each get the $22k average Social Security retirement benefit and draw 4% a year from your portfolio, your retirement budget could be $139k a year vs. his $95k a year.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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Disclaimer: This article is intended for informational purposes only and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.