Active Funds vs. Passive Funds: Who Takes the Lead?

Many investors are familiar with Warren Buffett's famous ten-year bet. In 2007, Buffett made a wager with fund manager Ted Seides: over the next ten years, Seides couldn't outperform the S&P 500 index. The bet began on January 1, 2008, and concluded on December 31, 2017, spanning the tumultuous period of the financial crisis. In 2017, Seides conceded defeat, and Buffett revealed the outcome.

 

According to data disclosed by Buffett at the 2017 shareholders' meeting, the annualized growth rate of index funds was 7.1%, while the annualized growth rate of the five hedge fund combinations chosen by Ted Seides was 2.2%. During this period, 87% of active US stock funds underperformed the S&P 500 index fund, with only 13% outperforming it.

 

Active Funds vs. Passive Funds

 

Active funds employ various methods such as stock selection, market timing, macro analysis, and technical chart analysis to beat the market and achieve excess returns. In contrast, passive funds replicate the market to obtain the average market return, often in the form of index funds like the S&P 500.

 

Although active funds allow investors to see the top ten holdings through regular reports, gain deeper insights into fund managers through their statements and interviews in periodic reports, and analyze the approximate investment style of fund managers through indicators such as holdings, industry, market value, valuation, turnover rate, etc., and conduct performance attribution analysis on funds; the investment strategy of active funds is not disclosed and transparent, and may face the dual uncertainties of drift in the investment style of fund managers and changes in fund managers.

 

Index funds are transparent in rules and holdings, with logical and reasonable rebalancing timing. However, the obvious disadvantage is the full-time operation, requiring investors to actively adjust their positions according to market conditions, which is also a challenge for ordinary investors.

 

In essence, active funds rely on the subjective initiative of fund managers, while index funds have established rules and strategies.

 

The Rise of Passive Investment: A Critical Analysis

 

Passive investment has seen a significant rise, notably overtaking active funds in scale by January 2024, marking a historical shift in the U.S. market. Behind this surge lies a growing realization among many in the U.S. market that active fund managers struggle to outperform benchmark indices.

 

Many large institutions, apart from managing their own investments, also require professional fund managers to handle assets, such as national or city pension funds, Harvard University's alumni donation funds, and more. For these institutions, the ability to select funds is their core competency.

 

Two scholars in the U.S. selected 417 pension funds and studied 8,755 fund selection decisions made by them between 1994 and 2003. They ultimately found that these decisions did not bring any value to the funds. Essentially, this is because outstanding active fund managers capable of generating excess returns are few and far between.

 

Even Peter Lynch is no exception.

 

Peter Lynch managed the legendary Magellan Fund under Fidelity from 1977 to 1990. Over these 13 years, Mr. Lynch achieved an astonishing annualized return of 29.2%.

 

However, if we divide Lynch's career into two periods, the first half indeed saw him as a legendary figure, consistently outperforming the market by over 25% annually. At this time, the fund he managed averaged around $400 million in size.

 

In the latter half, as most investors recognized Lynch's exceptional investment prowess and poured money into his fund, the fund's average size ballooned to $10 billion. Yet Lynch's average annual outperformance dropped from 25% to 1%.

 

Therefore, it can also be said that the majority of funds invested in Peter Lynch did not beat the market.

 

92% of U.S. Large-Cap Active Funds Underperform Index

 

Hamish Preston, the global head of S&P Dow Jones Indices, has stated that S&P Dow Jones Indices introduced SPIVA (S&P Indices Versus Active), aiming to compare the performance of active fund managers with benchmark indices. SPIVA is updated semi-annually. Over recent decades, SPIVA has consistently shown that the majority of active fund managers underperform the benchmarks.

 

For example, as of the end of June 2023, over the past year, 60% of U.S. large-cap active fund managers performed worse than the S&P 500 Index. As of the end of June 2023, over the past 15 years, approximately 92% of U.S. large-cap active fund managers performed worse than the S&P 500 Index. This trend holds true even when considering risk-adjusted returns. Moreover, the longer the time period considered, the higher the proportion of active funds underperforming the index.

 

Hamish Preston mentioned that many active funds struggle to outperform the market, with a key reason being costs. In the United States, the average cost of actively managed mutual funds is multiple times that of passively managed mutual funds (index funds). For an active fund manager, this means they must achieve higher returns than passive products to overcome the higher costs. Additionally, even without considering fee factors, in a fiercely competitive environment, it is difficult for a fund manager to outperform peers.

 

Over $8 Trillion! U.S. ETF Market Hits Record Size

 

Data from Morningstar shows that as of the end of 2023, the total assets under management of passive funds in the United States amounted to $13.293 trillion, while the total assets under management of active funds stood at $13.234 trillion. Note that the above statistics do not include money market funds and funds of funds (FOFs) but include exchange-traded open-end index funds (ETFs).

 

More data confirms the unstoppable growth of the U.S. ETF market.

 

A report from the independent research firm ETFGI stated that as of the end of 2023, the assets under management of the U.S. ETF industry reached a record $8.12 trillion. In December alone, U.S. ETFs attracted a net inflow of $1300.2 billion. Throughout 2023, net inflows into U.S. ETFs totaled $6039.8 billion. Combined with asset appreciation, the size of the U.S. ETF market increased by $1.61 trillion in 2023.

 

The significant net inflows were primarily driven by the top 20 ETFs by size. For example, in December 2023, the top 20 ETFs attracted a total net inflow of $85.8 billion. Among them, the SPDR S&P 500 ETF Trust (SPY) attracted a net inflow of $39.41 billion. SPY is the longest-standing and largest ETF in U.S. history.

 

How to Choose Passive Funds?

 

Passive funds primarily select specific indices and strive to track their performance. Among them, index funds are most common.

 

From the perspective of investment targets, indices can be categorized into broad-based indices, sector indices, thematic indices, etc. In terms of product types, index funds can be divided into index funds, enhanced index funds, ETFs, LOFs, etc.

 

Choosing index funds requires attention to two aspects:

 

Firstly, fees: Choose funds with lower fees under the same conditions.

 

Secondly, tracking error, i.e., the degree of deviation from the index. Select index funds with smaller tracking errors, as a smaller tracking error indicates stronger fund management capabilities, and investors are more likely to achieve their goal of tracking index movements.

 

In conclusion, active funds and passive funds are not mutually exclusive. From the perspective of asset allocation, allocating to both may better diversify portfolio risks.