Index Funds vs. Active Managed Funds… It’s been a battle of the ages! Let’s see the results!
Index funds and actively managed funds represent two major approaches to equity investing. Over the past two decades, researchers have compared their long-term performance, focusing on returns, risk, and the impact of expense ratios. This overview synthesizes findings from longitudinal and comparative studies, highlighting key insights for passive investors.
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Long-Term Performance Comparison of Index Funds vs Actively Managed Funds
Average Performance Trends:
Most studies find that, on average, actively managed funds do not consistently outperform passive index funds over long periods. In the Indian market (2006–2019), actively managed large-cap funds failed to outperform the market or passive funds on most risk-return measures, with only a slight edge in Jensen alpha (Shreekant et al., 2020). In broader US and international samples, the average actively managed fund underperforms low-cost index funds after accounting for fees and expenses, typically losing to benchmarks by about 0.41% annually (Petajisto, 2013; Malkiel and Saha, 2020).
Outliers and Skill:
A minority of highly active managers – those with high “Active Share” – can outperform their benchmarks, even after fees, by about 1.26% per year, while “closet indexers” (funds that closely track the index but charge active fees) consistently underperform (Petajisto, 2013). Some studies report that the best-performing active funds can beat passive portfolios by 3–5% per year, but these are exceptions rather than the rule (Blitz and Huij, 2012; Doshi, Elkamhi and Simutin, 2015).
Expense Ratios and Their Impact on Index Funds vs Actively Managed Funds
The Expense Ratio Effects:
Firstly, Expense ratios are a critical factor in long-term fund performance. Actively managed funds generally have higher expense ratios than index funds, which erode returns over time(Petajisto, 2013; Malkiel and Saha, 2020). Studies show that actively managed funds with lower expense ratios and lower turnover deliver better future performance than their higher-cost peers, and even outperform the average active fund(Malkiel and Saha, 2020). However, even low-cost passive funds may underperform their benchmark indexes due to their own (albeit smaller) expense ratios (Elton, Gruber and De Souza, 2019).
Fee Competition:
Despite the growth of passive investing, active fund fees have not significantly decreased in response to competition from index funds. In some cases, active funds facing more competition from passive products have even increased their fees (Carneiro, Júnior and Yoshinaga, 2021).
Types of Active Management and Performance Variation in Index Funds vs Actively Managed Funds
Active Management Styles:
Performance varies widely among active funds depending on their management style. Highly concentrated portfolios managed by single managers tend to perform better but also have higher expense ratios (Goldman, Sun and Zhou, 2016). Funds that are more active in stock selection (high Active Share) outperform, while those that mimic indexes (closet indexers) underperform after fees (Petajisto, 2013).
Market Conditions:
Active management tends to be less effective during periods of high market volatility, with abnormal performance declining in such times (Matallín?Sáez and De Mingo-López, 2024; Petajisto, 2013).
Passive Funds: Monitoring and Governance – Index Funds vs Actively Managed Funds
Governance Implications:
While index funds offer cost advantages, they are less effective at corporate governance compared to active funds. Index funds are less likely to challenge management on governance issues, potentially reducing shareholder oversight (Heath et al., 2020).
Conclusion: Key Insights
Over 20-year horizons, most actively managed funds underperform index funds after accounting for higher expense ratios. Only a small subset of highly active managers consistently add value, while most active funds – especially those with high fees or closet indexing strategies – lag behind. Expense ratios are a decisive factor: lower costs strongly correlate with better long-term outcomes. For most passive investors, low-cost index funds remain the most reliable choice for long-term equity exposure.
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References
- Blitz, D., & Huij, J., 2012. Another Look at the Performance of Actively Managed Equity Mutual Funds. Mutual Funds. https://doi.org/10.2139/ssrn.2004972
- Carneiro, L., Júnior, W., & Yoshinaga, C., 2021. The implications of passive investments for active fund management: International evidence. Global Finance Journal, pp. 100623. https://doi.org/10.1016/J.GFJ.2021.100623
- Doshi, H., Elkamhi, R., & Simutin, M., 2015. Managerial Activeness and Mutual Fund Performance. Australasian Finance & Banking Conferences. https://doi.org/10.2139/ssrn.2426630
- Shreekant, G., Rai, R., Raman, T., & Bhardwaj, G., 2020. Performance Evaluation of Actively Managed and Passive (Index) Mutual Funds in India. CGN: Shareholders in Corporate Governance (Topic). https://doi.org/10.34218/ijm.11.12.2020.104
- Heath, D., Macciocchi, D., Michaely, R., & Ringgenberg, M., 2020. Do Index Funds Monitor?. Corporate Finance: Governance. https://doi.org/10.2139/ssrn.3259433
- Matallín?Sáez, J., & De Mingo-López, D., 2024. The role of passive effects in the relationship between active management and short-term performance: Evidence from mutual fund portfolio holdings. Finance Research Letters. https://doi.org/10.1016/j.frl.2024.105107
- Elton, E., Gruber, M., & De Souza, A., 2019. Are Passive Funds Really Superior Investments? An Investor Perspective. Financial Analysts Journal, 75, pp. 19 – 7. https://doi.org/10.1080/0015198X.2019.1618097
- Petajisto, A., 2013. Active Share and Mutual Fund Performance. Financial Analysts Journal, 69, pp. 73 – 93. https://doi.org/10.2469/faj.v69.n4.7
- Goldman, E., Sun, Z., & Zhou, X., 2016. The Effect of Management Design on the Portfolio Concentration and Performance of Mutual Funds. Financial Analysts Journal, 72, pp. 49 – 61. https://doi.org/10.2469/faj.v72.n4.9
- Malkiel, B., & Saha, A., 2020. Mutual Fund Returns and Their Characteristics: A Simple Approach to Selecting Better Performing Actively-Managed Funds. **, 29, pp. 63 – 75. https://doi.org/10.3905/joi.2020.1.117
