Session 35 (of 42): The Case for Passive Investing - Active Investors' Track Record

Why It Matters

Understanding that active managers systematically underperform reshapes portfolio construction, steering investors toward low‑cost passive funds that reliably capture market returns.

Key Takeaways

• Passive funds now hold ~65% of market assets
• Most active managers underperform benchmarks by 1‑2% annually
• Individual investors’ frequent trading erodes returns versus market averages
• No style, size, or region consistently beats index funds long‑term
• Survivor bias inflates perceived active performance, masking true underperformance

Summary

The session examines whether investors should aim to beat the market or simply embrace passive strategies. It highlights the dramatic shift over four decades, with passive index funds and ETFs growing from a negligible share to roughly 65% of total market assets, while active ownership has fallen to about 35% in 2024.

Data from decades of academic research show that the average active manager—whether a mutual‑fund, hedge‑fund, or bond‑fund manager—fails to outpace the relevant benchmark. Jensen’s 1960s study found roughly 70% of mutual funds underperformed, delivering a negative alpha of 1‑1.5%. Later Carhart research confirmed a 1.8% annual shortfall after accounting for size, value, and momentum factors. Across styles, regions, and asset classes, fewer than half of active managers beat their indices in any given year, and long‑term success rates dip well below 50%.

The speaker cites concrete examples: individual investors who trade more earn lower returns; the top 10% of traders outperform the bottom 10% but may rely on luck. Survivor bias further distorts results—funds that perform poorly often close, inflating the apparent performance of surviving funds by about 0.17%. Even in emerging markets like South Africa or the Middle East, active managers only marginally exceed benchmarks in short windows, and indices dominate over ten‑year horizons.

The implication is clear for investors and advisors: passive vehicles consistently deliver higher risk‑adjusted returns at dramatically lower cost, making them the rational default choice. Active management’s promise of outperformance remains unsubstantiated across the board, suggesting that resources spent on costly research and frequent trading could be better allocated to low‑fee index exposure.

Original Description

In this session, we make the argument for passive investing by looking at the performance of active investors. We begin by looking at individual investors and note that they collectively under perform the market and that the under performance gets worse as they get more active. There is some cause for hope, though, since the very best investors do substantially out perform the market, especially if they stick to the companies that they know and don’t diversify too much. With mutual funds, the evidence is not favorable, since mutual funds under perform indices and the under performance cuts across all classes of mutual funds. Collectively, active investing does not seem to provide much of a payoff.

Playlist for class (Intro + 42 sessions): https://youtube.com/playlist?list=PLUkh9m2BorqnZGADa8cTzeJblmrZY_SqP&si=zI2pk17pJeld4nWR

Slides: https://www.stern.nyu.edu/~adamodar/pdfiles/invphilslides25/session35.pdf

Post-class test: https://www.stern.nyu.edu/~adamodar/pdfiles/invphilcertificate/postclass/session35test.pdf

Post-class solution: https://www.stern.nyu.edu/~adamodar/pdfiles/invphilcertificate/postclass/session35soln.pdf